Unfortunately for some shareholders, the Domtar (NYSE:UFS) share price has dived 36% in the last thirty days. Indeed the recent decline has arguably caused some bitterness for shareholders who have held through the 53% drop over twelve months.
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). 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 Domtar’s P/E Ratio Compare To Its Peers?
Domtar’s P/E of 16.76 indicates some degree of optimism towards the stock. You can see in the image below that the average P/E (11.8) for companies in the forestry industry is lower than Domtar’s P/E.
Domtar’s P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn’t guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Companies that shrink earnings per share quickly will rapidly decrease the ‘E’ in the equation. That means even if the current P/E is low, it will increase over time if the share price stays flat. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
Domtar saw earnings per share decrease by 69% last year. And EPS is down 27% a year, over the last 5 years. This could justify a pessimistic P/E.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
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. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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).
Is Debt Impacting Domtar’s P/E?
Net debt totals 68% of Domtar’s market cap. This is enough debt that you’d have to make some adjustments before using the P/E ratio to compare it to a company with net cash.
The Verdict On Domtar’s P/E Ratio
Domtar trades on a P/E ratio of 16.8, which is above its market average of 13.3. With meaningful debt and a lack of recent earnings growth, the market has high expectations that the business will earn more in the future. What can be absolutely certain is that the market has become significantly less optimistic about Domtar over the last month, with the P/E ratio falling from 26.3 back then to 16.8 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 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. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
But note: Domtar 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 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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