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A Sliding Share Price Has Us Looking At Downer EDI Limited's (ASX:DOW) P/E Ratio

Simply Wall St

Unfortunately for some shareholders, the Downer EDI (ASX:DOW) share price has dived 50% in the last thirty days. That drop has capped off a tough year for shareholders, with the share price down 58% in that time.

Assuming nothing else has changed, a lower share price makes a stock more attractive to potential buyers. 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. 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). Investors have optimistic expectations of companies with higher P/E ratios, compared to companies with lower P/E ratios.

View our latest analysis for Downer EDI

Does Downer EDI Have A Relatively High Or Low P/E For Its Industry?

Downer EDI's P/E of 9.36 indicates relatively low sentiment towards the stock. The image below shows that Downer EDI has a lower P/E than the average (16.8) P/E for companies in the commercial services industry.

ASX:DOW Price Estimation Relative to Market, March 19th 2020
ASX:DOW Price Estimation Relative to Market, March 19th 2020

Downer EDI's P/E tells us that market participants think it will not fare as well as its peers in the same industry. 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

Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means even if the current P/E is low, it will increase over time if the share price stays flat. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.

Downer EDI saw earnings per share decrease by 1.4% last year. And EPS is down 6.0% a year, over the last 5 years. So you wouldn't expect a very high P/E.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

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. 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.

Is Debt Impacting Downer EDI's P/E?

Downer EDI has net debt worth 66% of its market capitalization. This is enough debt that you'd have to make some adjustments before using the P/E ratio to compare it to a company with net cash.

The Bottom Line On Downer EDI's P/E Ratio

Downer EDI's P/E is 9.4 which is below average (13.3) in the AU market. Given meaningful debt, and a lack of recent growth, the market looks to be extrapolating this recent performance; reflecting low expectations for the future. Given Downer EDI's P/E ratio has declined from 18.9 to 9.4 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 invest in growth, this stock apparently offers limited promise, but the deep value investors may find the pessimism around this stock enticing.

Investors should be looking to buy stocks that the market is wrong about. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

Of course you might be able to find a better stock than Downer EDI. 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 editorial-team@simplywallst.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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.