To the annoyance of some shareholders, Kansas City Southern (NYSE:KSU) shares are down a considerable 33% in the last month. The bad news is that the recent drop obliterated the last year's worth of gains; the stock is flat over twelve months.
All else being equal, a share price drop should make a stock more attractive to potential investors. In the long term, share prices tend to follow earnings per share, but in the short term prices bounce around in response to short term factors (which are not always obvious). So, on certain occasions, long term focussed investors try to take advantage of pessimistic expectations to buy shares at a better price. 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 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 Kansas City Southern Have A Relatively High Or Low P/E For Its Industry?
Kansas City Southern's P/E of 21.12 indicates some degree of optimism towards the stock. You can see in the image below that the average P/E (15.8) for companies in the transportation industry is lower than Kansas City Southern's P/E.
That means that the market expects Kansas City Southern will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. When earnings grow, the 'E' increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Kansas City Southern shrunk earnings per share by 12% over the last year. But over the longer term (5 years) earnings per share have increased by 3.5%.
Remember: P/E Ratios Don't Consider The Balance Sheet
Don't forget that the P/E ratio considers market capitalization. So it won't reflect the advantage of cash, or disadvantage of debt. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
Is Debt Impacting Kansas City Southern's P/E?
Kansas City Southern has net debt equal to 28% of its market cap. While that's enough to warrant consideration, it doesn't really concern us.
The Verdict On Kansas City Southern's P/E Ratio
Kansas City Southern has a P/E of 21.1. That's higher than the average in its market, which is 13.3. With a bit of debt, but a lack of recent growth, it's safe to say the market is expecting improved profit performance from the company, in the next few years. Given Kansas City Southern's P/E ratio has declined from 31.5 to 21.1 in the last month, we know for sure that the market is significantly 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. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
You might be able to find a better buy than Kansas City Southern. 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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