Western Areas (ASX:WSA) shares have continued recent momentum with a 33% gain in the last month alone. And the full year gain of 15% isn't too shabby, either!
All else being equal, a sharp share price increase should make a stock less attractive to potential investors. While the market sentiment towards a stock is very changeable, in the long run, the share price will tend to move in the same direction as earnings per share. The implication here is that deep value investors might steer clear when expectations of a company are too high. Perhaps the simplest way to get a read on investors' expectations of a business is to look at its Price to Earnings Ratio (PE Ratio). A high P/E implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.
Does Western Areas Have A Relatively High Or Low P/E For Its Industry?
Western Areas's P/E of 60.50 indicates some degree of optimism towards the stock. As you can see below, Western Areas has a much higher P/E than the average company (13.2) in the metals and mining industry.
Western Areas's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Shareholders are clearly optimistic, but the future is always uncertain. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
How Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
It's great to see that Western Areas grew EPS by 20% in the last year. In contrast, EPS has decreased by 17%, annually, over 5 years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The 'Price' in P/E reflects the market capitalization of the company. So it won't reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
Is Debt Impacting Western Areas's P/E?
With net cash of AU$144m, Western Areas has a very strong balance sheet, which may be important for its business. Having said that, at 17% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On Western Areas's P/E Ratio
Western Areas's P/E is 60.5 which suggests the market is more focussed on the future opportunity rather than the current level of earnings. With cash in the bank the company has plenty of growth options -- and it is already on the right track. So it is not surprising the market is probably extrapolating recent growth well into the future, reflected in the relatively high P/E ratio. What is very clear is that the market has become significantly more optimistic about Western Areas over the last month, with the P/E ratio rising from 45.5 back then to 60.5 today. If you like to buy stocks that have recently impressed the market, then this one might be a candidate; but if you prefer to invest when there is 'blood in the streets', then you may feel the opportunity has passed.
Investors have an opportunity when market expectations about a stock are wrong. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course you might be able to find a better stock than Western Areas. So you may wish to see this free collection of other companies that have grown earnings strongly.
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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.