To the annoyance of some shareholders, Kip McGrath Education Centres (ASX:KME) shares are down a considerable 40% in the last month. Even longer term holders have taken a real hit with the stock declining 6.2% in the last year.
All else being equal, a share price drop should make a stock more attractive to potential investors. 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 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.
How Does Kip McGrath Education Centres’s P/E Ratio Compare To Its Peers?
Kip McGrath Education Centres’s P/E of 16.04 indicates relatively low sentiment towards the stock. We can see in the image below that the average P/E (23.5) for companies in the consumer services industry is higher than Kip McGrath Education Centres’s P/E.
This suggests that market participants think Kip McGrath Education Centres will underperform other companies in its industry. Since the market seems unimpressed with Kip McGrath Education Centres, it’s quite possible it could surprise on the upside. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
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. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Kip McGrath Education Centres saw earnings per share decrease by 1.3% last year. But over the longer term (5 years) earnings per share have increased by 19%.
Remember: P/E Ratios Don’t Consider The Balance Sheet
It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
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.
Kip McGrath Education Centres’s Balance Sheet
Since Kip McGrath Education Centres holds net cash of AU$3.9m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Kip McGrath Education Centres’s P/E Ratio
Kip McGrath Education Centres’s P/E is 16.0 which is below average (18.0) in the AU market. The recent drop in earnings per share would make investors cautious, the relatively strong balance sheet will allow the company time to invest in growth. If it achieves that, then there’s real potential that the low P/E could eventually indicate undervaluation. Given Kip McGrath Education Centres’s P/E ratio has declined from 26.8 to 16.0 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. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. We don’t have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E 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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