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Why GMS Inc.'s (NYSE:GMS) High P/E Ratio Isn't Necessarily A Bad Thing

Simply Wall St

Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use GMS Inc.'s (NYSE:GMS) P/E ratio to inform your assessment of the investment opportunity. GMS has a price to earnings ratio of 17.35, based on the last twelve months. That corresponds to an earnings yield of approximately 5.8%.

See our latest analysis for GMS

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for GMS:

P/E of 17.35 = $29.96 ÷ $1.73 (Based on the year to July 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.

How Does GMS's P/E Ratio Compare To Its Peers?

The P/E ratio indicates whether the market has higher or lower expectations of a company. You can see in the image below that the average P/E (17.1) for companies in the trade distributors industry is roughly the same as GMS's P/E.

NYSE:GMS Price Estimation Relative to Market, November 1st 2019

That indicates that the market expects GMS will perform roughly in line with other companies in its industry. If the company has better than average prospects, then the market might be underestimating it. Checking factors such as director buying and selling. could help you form your own view on if that will happen.

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. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

GMS increased earnings per share by a whopping 26% last year. And its annual EPS growth rate over 3 years is 47%. I'd therefore be a little surprised if its P/E ratio was not relatively high.

Remember: P/E Ratios Don't Consider The Balance Sheet

Don't forget that the P/E ratio considers market capitalization. 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 expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

Is Debt Impacting GMS's P/E?

GMS's net debt is 83% of its market cap. This is a reasonably significant level of debt -- all else being equal you'd expect a much lower P/E than if it had net cash.

The Verdict On GMS's P/E Ratio

GMS has a P/E of 17.3. That's around the same as the average in the US market, which is 17.8. While it does have meaningful debt levels, it has also produced strong earnings growth recently. However, the P/E ratio implies that most doubt the strong growth will continue.

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 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 GMS. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.

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. Thank you for reading.