To the annoyance of some shareholders, Advance Auto Parts (NYSE:AAP) 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 52% in that time.
Assuming nothing else has changed, a lower share price makes a stock more 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 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.
How Does Advance Auto Parts's P/E Ratio Compare To Its Peers?
We can tell from its P/E ratio of 12.32 that there is some investor optimism about Advance Auto Parts. The image below shows that Advance Auto Parts has a higher P/E than the average (6.5) P/E for companies in the specialty retail industry.
Its relatively high P/E ratio indicates that Advance Auto Parts shareholders think it will perform better than other companies in its industry classification. Clearly the market expects growth, but it isn't guaranteed. 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
Earnings growth rates have a big influence on P/E ratios. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. 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.
Most would be impressed by Advance Auto Parts earnings growth of 19% in the last year. And its annual EPS growth rate over 3 years is 3.2%. With that performance, you might expect an above average P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
Don't forget that the P/E ratio considers market capitalization. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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.
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
Is Debt Impacting Advance Auto Parts's P/E?
Net debt totals just 5.6% of Advance Auto Parts's market cap. It would probably trade on a higher P/E ratio if it had a lot of cash, but I doubt it is having a big impact.
The Verdict On Advance Auto Parts's P/E Ratio
Advance Auto Parts has a P/E of 12.3. That's around the same as the average in the US market, which is 12.2. Given it has reasonable debt levels, and grew earnings strongly last year, the P/E indicates the market has doubts this growth can be sustained. Given Advance Auto Parts's P/E ratio has declined from 18.5 to 12.3 in the last month, we know for sure that the market is significantly less confident about the business today, than it was back then. 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. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
Of course you might be able to find a better stock than Advance Auto Parts. So you may wish to see this free collection of other companies that have grown earnings strongly.
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