To the annoyance of some shareholders, Paragon Care (ASX:PGC) shares are down a considerable 37% in the last month. That drop has capped off a tough year for shareholders, with the share price down 52% in that time.
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). The implication here is that long term investors have an opportunity when expectations of a company are too low. One way to gauge market expectations of a stock is to look at its Price to Earnings Ratio (PE Ratio). Investors have optimistic expectations of companies with higher P/E ratios, compared to companies with lower P/E ratios.
Does Paragon Care Have A Relatively High Or Low P/E For Its Industry?
We can tell from its P/E ratio of 10.03 that sentiment around Paragon Care isn't particularly high. The image below shows that Paragon Care has a lower P/E than the average (19.3) P/E for companies in the healthcare industry.
Paragon Care's P/E tells us that market participants think it will not fare as well as its peers in the same industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
When earnings fall, the 'E' decreases, over time. That means unless the share price falls, the P/E will increase in a few years. Then, a higher P/E might scare off shareholders, pushing the share price down.
Paragon Care saw earnings per share decrease by 60% last year. But it has grown its earnings per share by 7.0% per year over the last five years. And over the longer term (3 years) earnings per share have decreased 21% annually. This might lead to low expectations.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. Thus, the metric does not reflect cash or debt held by the company. 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.
Paragon Care's Balance Sheet
Paragon Care has net debt worth 68% of its market capitalization. This is a reasonably significant level of debt -- all else being equal you'd expect a much lower P/E than if it had net cash.
The Bottom Line On Paragon Care's P/E Ratio
Paragon Care has a P/E of 10.0. That's below the average in the AU market, which is 18.8. When you consider that the company has significant debt, and didn't grow EPS last year, it isn't surprising that the market has muted expectations. What can be absolutely certain is that the market has become significantly less optimistic about Paragon Care over the last month, with the P/E ratio falling from 15.9 back then to 10.0 today. For those who don't like to trade against momentum, that could be a warning sign, but a contrarian investor might want to take a closer look.
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. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
You might be able to find a better buy than Paragon Care. 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).
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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