To the annoyance of some shareholders, CF Industries Holdings (NYSE:CF) shares are down a considerable 33% in the last month. That drop has capped off a tough year for shareholders, with the share price down 34% in that time.
All else being equal, a share price drop should make a stock more attractive to potential investors. 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 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 CF Industries Holdings Have A Relatively High Or Low P/E For Its Industry?
CF Industries Holdings's P/E of 12.66 indicates relatively low sentiment towards the stock. If you look at the image below, you can see CF Industries Holdings has a lower P/E than the average (17.3) in the chemicals industry classification.
Its relatively low P/E ratio indicates that CF Industries Holdings shareholders think it will struggle to do as well as other companies in its industry classification. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or selling.
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. Earnings growth means that in the future the 'E' will be higher. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
In the last year, CF Industries Holdings grew EPS like Taylor Swift grew her fan base back in 2010; the 80% gain was both fast and well deserved. Unfortunately, earnings per share are down 16% a year, over 5 years.
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. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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.
So What Does CF Industries Holdings's Balance Sheet Tell Us?
CF Industries Holdings has net debt worth 60% 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 CF Industries Holdings's P/E Ratio
CF Industries Holdings trades on a P/E ratio of 12.7, which is below the US market average of 14.7. The company has a meaningful amount of debt on the balance sheet, but that should not eclipse the solid earnings growth. If it continues to grow, then the current low P/E may prove to be unjustified. What can be absolutely certain is that the market has become significantly less optimistic about CF Industries Holdings over the last month, with the P/E ratio falling from 18.8 back then to 12.7 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.
Investors have an opportunity when market expectations about a stock are wrong. 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.
You might be able to find a better buy than CF Industries Holdings. 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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