It's great to see L Brands (NYSE:LB) shareholders have their patience rewarded with a 32% share price pop in the last month. But shareholders may not all be feeling jubilant, since the share price is still down 15% in the last year.
Assuming no other changes, a sharply higher share price makes a stock less attractive to potential buyers. 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 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). A high P/E implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.
How Does L Brands's P/E Ratio Compare To Its Peers?
L Brands's P/E of 17.42 indicates some degree of optimism towards the stock. You can see in the image below that the average P/E (16.2) for companies in the specialty retail industry is lower than L Brands's P/E.
Its relatively high P/E ratio indicates that L Brands shareholders think it will perform better than other companies in its industry classification. 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
If earnings fall then in the future the 'E' will be lower. That means even if the current P/E is low, it will increase over time if the share price stays flat. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.
L Brands shrunk earnings per share by 52% over the last year. And over the longer term (5 years) earnings per share have decreased 17% annually. This growth rate might warrant a below average P/E ratio.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
The 'Price' in P/E reflects the market capitalization of the company. So it won't reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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 L Brands's Balance Sheet Tell Us?
Net debt totals 81% of L Brands's market cap. 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 Verdict On L Brands's P/E Ratio
L Brands trades on a P/E ratio of 17.4, which is fairly close to the US market average of 18.0. With significant debt and no EPS growth last year, the P/E suggests shareholders are expecting higher profit in the future. What we know for sure is that investors have become more excited about L Brands recently, since they have pushed its P/E ratio from 13.2 to 17.4 over the last month. 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.
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 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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