To the annoyance of some shareholders, Kip McGrath Education Centres (ASX:KME) shares are down a considerable 45% in the last month. Even longer term holders have taken a real hit with the stock declining 8.3% 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). 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 implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.
Does Kip McGrath Education Centres Have A Relatively High Or Low P/E For Its Industry?
Kip McGrath Education Centres has a P/E ratio of 14.54. You can see in the image below that the average P/E (15.6) for companies in the consumer services industry is roughly the same as Kip McGrath Education Centres’s P/E.
That indicates that the market expects Kip McGrath Education Centres will perform roughly in line with other companies in its industry. The company could surprise by performing better than average, in the future. 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. When earnings grow, the ‘E’ increases, over time. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.
Kip McGrath Education Centres’s earnings per share fell by 1.3% in the last twelve months. But it has grown its earnings per share by 19% per year over the last five years.
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. 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.
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 Kip McGrath Education Centres’s Balance Sheet Tell Us?
The extra options and safety that comes with Kip McGrath Education Centres’s AU$3.9m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Verdict On Kip McGrath Education Centres’s P/E Ratio
Kip McGrath Education Centres’s P/E is 14.5 which is above average (13.3) in its market. Falling earnings per share is probably keeping traditional value investors away, but the net cash position means the company has time to improve: and the high P/E suggests the market thinks it will. Given Kip McGrath Education Centres’s P/E ratio has declined from 26.3 to 14.5 in the last month, we know for sure that the market is significantly less confident about the business today, than it was back then. 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 have an opportunity when market expectations about a stock are wrong. 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. Although we don’t have analyst forecasts you could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.
Of course you might be able to find a better stock than Kip McGrath Education Centres. 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 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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