To the annoyance of some shareholders, McGrath RentCorp (NASDAQ:MGRC) shares are down a considerable 31% in the last month. The recent drop has obliterated the annual return, with the share price now down 4.0% over that longer period.
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 McGrath RentCorp’s P/E Ratio Compare To Its Peers?
We can tell from its P/E ratio of 13.86 that sentiment around McGrath RentCorp isn’t particularly high. If you look at the image below, you can see McGrath RentCorp has a lower P/E than the average (25.2) in the commercial services industry classification.
This suggests that market participants think McGrath RentCorp will underperform other companies in its 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
Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the ‘E’ will be higher. And in that case, the P/E ratio itself will drop rather quickly. Then, a lower P/E should attract more buyers, pushing the share price up.
Most would be impressed by McGrath RentCorp earnings growth of 21% in the last year. And it has bolstered its earnings per share by 18% per year over the last five years. This could arguably justify a relatively high P/E ratio.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
The ‘Price’ in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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).
So What Does McGrath RentCorp’s Balance Sheet Tell Us?
McGrath RentCorp’s net debt is 22% of its market cap. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.
The Verdict On McGrath RentCorp’s P/E Ratio
McGrath RentCorp has a P/E of 13.9. That’s below the average in the US market, which is 15.1. 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 McGrath RentCorp’s P/E ratio has declined from 20.0 to 13.9 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 don’t like to trade against momentum, that could be a warning sign, but a contrarian investor might want to take a closer look.
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.
But note: McGrath RentCorp 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 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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.