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Denny's (NASDAQ:DENN) shareholders are no doubt pleased to see that the share price has bounced 82% in the last month alone, although it is still down 57% over the last quarter. But shareholders may not all be feeling jubilant, since the share price is still down 47% in the last year.
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. 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). Investors have optimistic expectations of companies with higher P/E ratios, compared to companies with lower P/E ratios.
Does Denny's Have A Relatively High Or Low P/E For Its Industry?
Denny's's P/E of 4.64 indicates relatively low sentiment towards the stock. We can see in the image below that the average P/E (12.7) for companies in the hospitality industry is higher than Denny's's P/E.
Its relatively low P/E ratio indicates that Denny's shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Denny's, it's quite possible it could surprise on the upside. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. 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.
Denny's's earnings made like a rocket, taking off 184% last year. The sweetener is that the annual five year growth rate of 39% is also impressive. With that kind of growth rate we would generally expect a high P/E ratio.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won't reflect the advantage of cash, or disadvantage of debt. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
How Does Denny's's Debt Impact Its P/E Ratio?
Denny's's net debt is 55% of its market cap. This is enough debt that you'd have to make some adjustments before using the P/E ratio to compare it to a company with net cash.
The Verdict On Denny's's P/E Ratio
Denny's's P/E is 4.6 which is below average (13.2) in the US market. The company may have significant debt, but EPS growth was good last year. If the company can continue to grow earnings, then the current P/E may be unjustifiably low. What is very clear is that the market has become less pessimistic about Denny's over the last month, with the P/E ratio rising from 2.6 back then to 4.6 today. If you like to buy stocks that could be turnaround opportunities, then this one might be a candidate; but if you're more sensitive to price, then you may feel the opportunity has passed.
Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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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