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To the annoyance of some shareholders, Rexnord (NYSE:RXN) shares are down a considerable 38% in the last month. Even longer term holders have taken a real hit with the stock declining 19% in the last year.
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. So, on certain occasions, long term focussed investors try to take advantage of pessimistic expectations to buy shares at a better price. 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 implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.
Does Rexnord Have A Relatively High Or Low P/E For Its Industry?
We can tell from its P/E ratio of 13.02 that sentiment around Rexnord isn't particularly high. We can see in the image below that the average P/E (16.0) for companies in the machinery industry is higher than Rexnord's P/E.
This suggests that market participants think Rexnord will underperform other companies in its 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
P/E ratios primarily reflect market expectations around earnings growth rates. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. 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.
Rexnord's earnings per share were pretty steady over the last year. But EPS is up 13% over the last 5 years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. That means it doesn't take debt or cash into account. 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 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 Rexnord's Balance Sheet Tell Us?
Net debt is 32% of Rexnord's market cap. While that's enough to warrant consideration, it doesn't really concern us.
The Verdict On Rexnord's P/E Ratio
Rexnord has a P/E of 13.0. That's around the same as the average in the US market, which is 13.3. When you consider the lack of EPS growth last year (along with some debt), it seems the market is optimistic about the future for the business. What can be absolutely certain is that the market has become significantly less optimistic about Rexnord over the last month, with the P/E ratio falling from 21.0 back then to 13.0 today. For those who prefer to invest with the flow of momentum, that might be a bad sign, but for a contrarian, it may signal opportunity.
Investors have an opportunity when market expectations about a stock are wrong. 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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
Of course you might be able to find a better stock than Rexnord. So you may wish to see this free collection of other companies that have grown earnings strongly.
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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