To the annoyance of some shareholders, adidas (ETR:ADS) shares are down a considerable 39% in the last month. The recent drop has obliterated the annual return, with the share price now down 18% over that longer period.
All else being equal, a share price drop should make a stock more attractive to potential investors. 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). So, on certain occasions, long term focussed investors try to take advantage of pessimistic expectations to buy shares at a better price. One way to gauge market expectations of a stock 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 adidas Have A Relatively High Or Low P/E For Its Industry?
adidas’s P/E is 18.87. You can see in the image below that the average P/E (18.9) for companies in the luxury industry is roughly the same as adidas’s P/E.
Its P/E ratio suggests that adidas shareholders think that in the future it will perform about the same as other companies in its industry classification. So if adidas actually outperforms its peers going forward, that should be a positive for the share price. Further research into factors such as insider buying and selling, could help you form your own view on whether that is likely.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. 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.
It’s great to see that adidas grew EPS by 16% in the last year. And it has bolstered its earnings per share by 26% per year over the last five years. This could arguably justify a relatively high P/E ratio.
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. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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 adidas’s Balance Sheet Tell Us?
Since adidas holds net cash of €1.0b, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On adidas’s P/E Ratio
adidas’s P/E is 18.9 which is above average (16.8) in its market. Its strong balance sheet gives the company plenty of resources for extra growth, and it has already proven it can grow. Therefore it seems reasonable that the market would have relatively high expectations of the company What can be absolutely certain is that the market has become significantly less optimistic about adidas over the last month, with the P/E ratio falling from 31.1 back then to 18.9 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. People often underestimate remarkable growth — so investors can make money when fast growth is not fully appreciated. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
But note: adidas 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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