Of late the E-L Financial (TSE:ELF) share price has softened like an ice cream in the sun, melting a full . But plenty of shareholders will still be smiling, given that the stock is up 9.0% over the last quarter. Indeed, the recent drop has reduced the annual gain to a relatively sedate 6.6% over the last twelve months.
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. One way to gauge market expectations of a stock is to look at its Price to Earnings Ratio (PE Ratio). A high P/E ratio means that investors have a high expectation about future growth, while a low P/E ratio means they have low expectations about future growth.
Does E-L Financial Have A Relatively High Or Low P/E For Its Industry?
E-L Financial's P/E of 15.80 indicates some degree of optimism towards the stock. As you can see below, E-L Financial has a higher P/E than the average company (14.2) in the insurance industry.
E-L Financial's P/E tells us that market participants think the company will perform better than its industry peers, going forward. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means even if the current P/E is low, it will increase over time if the share price stays flat. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
E-L Financial saw earnings per share decrease by 60% last year. And EPS is down 17% a year, over the last 5 years. This might lead to muted expectations.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. So it won't reflect the advantage of cash, or disadvantage of debt. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
So What Does E-L Financial's Balance Sheet Tell Us?
E-L Financial's net debt is 2.4% of its market cap. So it doesn't have as many options as it would with net cash, but its debt would not have much of an impact on its P/E ratio.
The Verdict On E-L Financial's P/E Ratio
E-L Financial trades on a P/E ratio of 15.8, which is fairly close to the CA market average of 15.8. When you consider the lack of EPS growth last year (along with some debt), it seems the market is optimistic about the future for the business. Given E-L Financial's P/E ratio has declined from 15.8 to 15.8 in the last month, we know for sure that the market is less confident about the business today, than it was back then. For those who prefer to invest with the flow of momentum, that might be a bad sign, but for a contrarian, it may signal opportunity.
When the market is wrong about a stock, it gives savvy investors an opportunity. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. We don't have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than E-L Financial. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
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