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To the annoyance of some shareholders, Valvoline (NYSE:VVV) shares are down a considerable 36% in the last month. The recent drop has obliterated the annual return, with the share price now down 24% over that longer period.
All else being equal, a share price drop should make a stock more attractive to potential investors. 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). 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). 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.
Does Valvoline Have A Relatively High Or Low P/E For Its Industry?
We can tell from its P/E ratio of 11.63 that sentiment around Valvoline isn't particularly high. The image below shows that Valvoline has a lower P/E than the average (14.9) P/E for companies in the chemicals industry.
Valvoline's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Many investors like to buy stocks when the market is pessimistic about their prospects. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
If earnings fall then in the future the 'E' will be lower. That means unless the share price falls, the P/E will increase in a few years. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.
Valvoline maintained roughly steady earnings over the last twelve months. But it has grown its earnings per share by 7.4% per year over the last five years. And EPS is down 9.9% a year, over the last 3 years. So it would be surprising to see a high P/E.
Remember: P/E Ratios Don't Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
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 Valvoline's Debt Impact Its P/E Ratio?
Net debt is 45% of Valvoline's market cap. While that's enough to warrant consideration, it doesn't really concern us.
The Verdict On Valvoline's P/E Ratio
Valvoline trades on a P/E ratio of 11.6, which is below the US market average of 12.7. The company hasn't stretched its balance sheet, and earnings are improving. The P/E ratio implies the market is cautious about longer term prospects. What can be absolutely certain is that the market has become significantly less optimistic about Valvoline over the last month, with the P/E ratio falling from 18.2 back then to 11.6 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 should be looking to buy stocks that the market is wrong about. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
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 firstname.lastname@example.org. 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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