Unfortunately for some shareholders, the Toll Brothers (NYSE:TOL) share price has dived 38% in the last thirty days. Even longer term holders have taken a real hit with the stock declining 15% in the last year.
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. Perhaps the simplest way to get a read on investors' expectations of a business is to look at its Price to Earnings Ratio (PE Ratio). A high P/E ratio means that investors have a high expectation about future growth, while a low P/E ratio means they have low expectations about future growth.
Does Toll Brothers Have A Relatively High Or Low P/E For Its Industry?
We can tell from its P/E ratio of 8.19 that sentiment around Toll Brothers isn't particularly high. If you look at the image below, you can see Toll Brothers has a lower P/E than the average (10.2) in the consumer durables industry classification.
This suggests that market participants think Toll Brothers will underperform other companies in its industry. Since the market seems unimpressed with Toll Brothers, it's quite possible it could surprise on the upside. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and 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. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Toll Brothers saw earnings per share decrease by 23% last year. But it has grown its earnings per share by 12% per year over the last five years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. That means it doesn't take debt or cash into account. 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).
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
Is Debt Impacting Toll Brothers's P/E?
Net debt totals 90% of Toll Brothers's market cap. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.
The Bottom Line On Toll Brothers's P/E Ratio
Toll Brothers trades on a P/E ratio of 8.2, which is below the US market average of 14.7. When you consider that the company has significant debt, and didn't grow EPS last year, it isn't surprising that the market has muted expectations. Given Toll Brothers's P/E ratio has declined from 13.2 to 8.2 in the last month, we know for sure that the market is more worried about the business today, than it was back then. For those who prefer to invest with the flow of momentum, that might be a bad sign, but for deep value investors this stock might justify some research.
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 visual report on analyst forecasts could hold the key to an excellent investment decision.
But note: Toll Brothers may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio 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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