Sims Metal Management (ASX:SGM) shareholders are no doubt pleased to see that the share price has had a great month, posting a 31% gain, recovering from prior weakness. The bad news is that even after that recovery shareholders are still underwater by about 2.9% for the full year.
All else being equal, a sharp share price increase should make a stock less 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 deep value investors might steer clear when expectations of a company are too high. One way to gauge market expectations of a stock 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 Sims Metal Management’s P/E Ratio Compare To Its Peers?
We can tell from its P/E ratio of 16.73 that there is some investor optimism about Sims Metal Management. You can see in the image below that the average P/E (12.7) for companies in the metals and mining industry is lower than Sims Metal Management’s P/E.
Its relatively high P/E ratio indicates that Sims Metal Management shareholders think it will perform better than other companies in its industry classification.
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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Sims Metal Management saw earnings per share decrease by 26% last year. But it has grown its earnings per share by 57% per year over the last five years.
Remember: P/E Ratios Don’t Consider The Balance Sheet
Don’t forget that the P/E ratio considers market capitalization. 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.
Sims Metal Management’s Balance Sheet
Sims Metal Management has net cash of AU$362m. This is fairly high at 14% of its market capitalization. That might mean balance sheet strength is important to the business, but should also help push the P/E a bit higher than it would otherwise be.
The Verdict On Sims Metal Management’s P/E Ratio
Sims Metal Management has a P/E of 16.7. That’s around the same as the average in the AU market, which is 18. While the absence of growth in the last year is probably causing a degree of pessimism, the net cash position means it’s not surprising that expectations put the company roughly in line with the market average P/E. What we know for sure is that investors have become much more excited about Sims Metal Management recently, since they have pushed its P/E ratio from 12.8 to 16.7 over the last month. For those who prefer to invest with the flow of momentum, that might mean it’s time to put the stock on a watchlist, or research it. But the contrarian may see it as a missed opportunity.
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 report on the analyst consensus forecasts could help you make a master move on this stock.
But note: Sims Metal Management 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).
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