Despite Its High P/E Ratio, Is ARB Corporation Limited (ASX:ARB) Still Undervalued?

This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we’ll show how ARB Corporation Limited’s (ASX:ARB) P/E ratio could help you assess the value on offer. ARB has a P/E ratio of 26.39, based on the last twelve months. That means that at current prices, buyers pay A$26.39 for every A$1 in trailing yearly profits.

View our latest analysis for ARB

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for ARB:

P/E of 26.39 = A$18.24 ÷ A$0.69 (Based on the year to December 2018.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.

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. 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.

ARB increased earnings per share by an impressive 11% over the last twelve months. And it has bolstered its earnings per share by 3.8% per year over the last five years. This could arguably justify a relatively high P/E ratio.

Does ARB Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio essentially measures market expectations of a company. The image below shows that ARB has a higher P/E than the average (15) P/E for companies in the auto components industry.

ASX:ARB Price Estimation Relative to Market, April 23rd 2019
ASX:ARB Price Estimation Relative to Market, April 23rd 2019

That means that the market expects ARB will outperform other companies in its industry. Clearly the market expects growth, but it isn’t guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.

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. 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.

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.

So What Does ARB’s Balance Sheet Tell Us?

Since ARB holds net cash of AU$5.2m, it can spend on growth, justifying a higher P/E ratio than otherwise.

The Verdict On ARB’s P/E Ratio

ARB trades on a P/E ratio of 26.4, which is above the AU market average of 16.1. Its strong balance sheet gives the company plenty of resources for extra growth, and it has already proven it can grow. Therefore it seems reasonable that the market would have relatively high expectations of the company

Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free report on the analyst consensus forecasts could help you make a master move on this stock.

But note: ARB 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).

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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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. Thank you for reading.