To the annoyance of some shareholders, Arch Capital Group (NASDAQ:ACGL) shares are down a considerable 35% in the last month. The recent drop has obliterated the annual return, with the share price now down 6.7% over that longer period.
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. 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). 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 Arch Capital Group’s P/E Ratio Compare To Its Peers?
Arch Capital Group’s P/E of 7.73 indicates relatively low sentiment towards the stock. The image below shows that Arch Capital Group has a lower P/E than the average (9.0) P/E for companies in the insurance industry.
Its relatively low P/E ratio indicates that Arch Capital Group shareholders think it will struggle to do as well as other companies in its industry classification. Many investors like to buy stocks when the market is pessimistic about their prospects. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. Earnings growth means that in the future the ‘E’ will be higher. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.
Arch Capital Group’s 125% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. And earnings per share have improved by 29% annually, over the last three years. So you might say it really deserves to have an above-average P/E ratio.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The ‘Price’ in P/E reflects the market capitalization of the company. So it won’t reflect the advantage of cash, or disadvantage of debt. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
While growth expenditure doesn’t always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
How Does Arch Capital Group’s Debt Impact Its P/E Ratio?
Net debt totals just 5.5% of Arch Capital Group’s market cap. The market might award it a higher P/E ratio if it had net cash, but its unlikely this low level of net borrowing is having a big impact on the P/E multiple.
The Verdict On Arch Capital Group’s P/E Ratio
Arch Capital Group has a P/E of 7.7. That’s below the average in the US market, which is 13.3. The company hasn’t stretched its balance sheet, and earnings growth was good last year. If the company can continue to grow earnings, then the current P/E may be unjustifiably low. Given Arch Capital Group’s P/E ratio has declined from 11.9 to 7.7 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 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 report on the analyst consensus forecasts could help you make a master move on this stock.
You might be able to find a better buy than Arch Capital 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 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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