Unfortunately for some shareholders, the GMS (NYSE:GMS) share price has dived 31% in the last thirty days. Indeed, the recent drop has reduced the annual gain to a relatively sedate 2.4% over the last twelve months.
Assuming nothing else has changed, a lower share price makes a stock more attractive to potential buyers. 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, on certain occasions, long term focussed investors try to take advantage of pessimistic expectations to buy shares at a better price. One way to gauge market expectations of a stock is to look at its Price to Earnings Ratio (PE Ratio). Investors have optimistic expectations of companies with higher P/E ratios, compared to companies with lower P/E ratios.
How Does GMS’s P/E Ratio Compare To Its Peers?
We can tell from its P/E ratio of 7.94 that sentiment around GMS isn’t particularly high. We can see in the image below that the average P/E (11.1) for companies in the trade distributors industry is higher than GMS’s P/E.
This suggests that market participants think GMS will underperform other companies in its industry. Since the market seems unimpressed with GMS, it’s quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. If earnings are growing quickly, then the ‘E’ in the equation will increase faster than it would otherwise. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
In the last year, GMS grew EPS like Taylor Swift grew her fan base back in 2010; the 66% gain was both fast and well deserved. And earnings per share have improved by 20% annually, over the last three years. So you might say it really deserves to have an above-average P/E ratio.
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. So it won’t reflect the advantage of cash, or disadvantage of debt. 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).
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
GMS’s Balance Sheet
GMS’s net debt is considerable, at 141% of its market cap. If you want to compare its P/E ratio to other companies, you must keep in mind that these debt levels would usually warrant a relatively low P/E.
The Verdict On GMS’s P/E Ratio
GMS trades on a P/E ratio of 7.9, which is below the US market average of 13.0. The company may have significant debt, but EPS growth was good last year. If the company can continue to grow earnings, then the current P/E may be unjustifiably low. What can be absolutely certain is that the market has become more pessimistic about GMS over the last month, with the P/E ratio falling from 11.5 back then to 7.9 today. For those who prefer invest in growth, this stock apparently offers limited promise, but the deep value investors may find the pessimism around this stock enticing.
Investors should be looking to buy stocks that the market is wrong about. 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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
Of course you might be able to find a better stock than GMS. So you may wish to see this free collection of other companies that have grown earnings strongly.
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.
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