To the annoyance of some shareholders, GWA Group (ASX:GWA) shares are down a considerable 33% in the last month. Even longer term holders have taken a real hit with the stock declining 20% in the last year.
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. 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.
How Does GWA Group's P/E Ratio Compare To Its Peers?
GWA Group's P/E of 16.35 indicates some degree of optimism towards the stock. The image below shows that GWA Group has a higher P/E than the average (12.5) P/E for companies in the building industry.
Its relatively high P/E ratio indicates that GWA Group shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn't guarantee future growth. 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
Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means unless the share price falls, the P/E will increase in a few years. Then, a higher P/E might scare off shareholders, pushing the share price down.
GWA Group shrunk earnings per share by 14% over the last year. But EPS is up 19% over the last 5 years. And over the longer term (3 years) earnings per share have decreased 7.0% annually. This growth rate might warrant a low P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
The 'Price' in P/E reflects the market capitalization of the company. That means it doesn't take debt or cash into account. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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).
So What Does GWA Group's Balance Sheet Tell Us?
Net debt totals 21% of GWA Group's market cap. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.
The Bottom Line On GWA Group's P/E Ratio
GWA Group trades on a P/E ratio of 16.4, which is above its market average of 13.9. With modest debt but no EPS growth in the last year, it's fair to say the P/E implies some optimism about future earnings, from the market. What can be absolutely certain is that the market has become significantly less optimistic about GWA Group over the last month, with the P/E ratio falling from 24.5 back then to 16.4 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 should be looking to buy stocks that the market is wrong about. 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.
You might be able to find a better buy than GWA Group. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
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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