It’s really great to see that even after a strong run, Fortescue Metals Group (ASX:FMG) shares have been powering on, with a gain of 34% in the last thirty days. Looking back a bit further, we’re also happy to report the stock is up 89% in the last year.
All else being equal, a sharp share price increase should make a stock less 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 some would prefer to hold off buying when there is a lot of optimism towards a stock. 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 Fortescue Metals Group Have A Relatively High Or Low P/E For Its Industry?
Fortescue Metals Group’s P/E of 6.16 indicates relatively low sentiment towards the stock. If you look at the image below, you can see Fortescue Metals Group has a lower P/E than the average (10.1) in the metals and mining industry classification.
Fortescue Metals Group’s P/E tells us that market participants think it will not fare as well as its peers in the same industry. 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
P/E ratios primarily reflect market expectations around earnings growth rates. 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.
In the last year, Fortescue Metals Group grew EPS like Taylor Swift grew her fan base back in 2010; the 498% gain was both fast and well deserved. The cherry on top is that the five year growth rate was an impressive 30% per year. So I’d be surprised if the P/E ratio was not above average.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
Don’t forget that the P/E ratio considers market capitalization. So it won’t reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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.
How Does Fortescue Metals Group’s Debt Impact Its P/E Ratio?
Since Fortescue Metals Group holds net cash of US$110m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Fortescue Metals Group’s P/E Ratio
Fortescue Metals Group has a P/E of 6.2. That’s below the average in the AU market, which is 15.6. The net cash position gives plenty of options to the business, and the recent improvement in EPS is good to see. The relatively low P/E ratio implies the market is pessimistic. What we know for sure is that investors are becoming less uncomfortable about Fortescue Metals Group’s prospects, since they have pushed its P/E ratio from 4.6 to 6.2 over the last month. If you like to buy stocks that could be turnaround opportunities, then this one might be a candidate; but if you’re more sensitive to price, then you may feel the opportunity has passed.
When the market is wrong about a stock, it gives savvy investors an opportunity. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
You might be able to find a better buy than Fortescue Metals 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).
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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned. Thank you for reading.