ResMed (NYSE:RMD) shares have had a really impressive month, gaining 44%, after some slippage. That brought the twelve month gain to a very sharp 65%.
Assuming no other changes, a sharply higher share price makes a stock less attractive to potential buyers. 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. So some would prefer to hold off buying when there is a lot of optimism towards a stock. 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.
How Does ResMed's P/E Ratio Compare To Its Peers?
ResMed's P/E of 52.17 indicates some degree of optimism towards the stock. The image below shows that ResMed has a higher P/E than the average (44.7) P/E for companies in the medical equipment industry.
That means that the market expects ResMed will outperform other companies in its industry. 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
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. And in that case, the P/E ratio itself will drop rather quickly. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
ResMed's earnings per share were pretty steady over the last year. But it has grown its earnings per share by 4.8% per year over the last five years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. That means it doesn't take debt or cash into account. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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).
So What Does ResMed's Balance Sheet Tell Us?
ResMed has net debt worth just 4.6% of its market capitalization. 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 ResMed's P/E Ratio
With a P/E ratio of 52.2, ResMed is expected to grow earnings very strongly in the years to come. Given the debt is only modest, and earnings are already moving in the right direction, it's not surprising that the market expects continued improvement. What is very clear is that the market has become significantly more optimistic about ResMed over the last month, with the P/E ratio rising from 36.1 back then to 52.2 today. For those who prefer to invest with the flow of momentum, that might mean it's time to put the stock on a watchlist, or research it. But the contrarian may see it as a missed opportunity.
Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. 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 ResMed. So you may wish to see this free collection of other companies that have grown earnings strongly.
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.
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