McGrath Limited (ASX:MEA) Might Not Be As Mispriced As It Looks

When close to half the companies in Australia have price-to-earnings ratios (or "P/E's") above 20x, you may consider McGrath Limited (ASX:MEA) as an attractive investment with its 12.1x P/E ratio. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the reduced P/E.

For instance, McGrath's receding earnings in recent times would have to be some food for thought. One possibility is that the P/E is low because investors think the company won't do enough to avoid underperforming the broader market in the near future. However, if this doesn't eventuate then existing shareholders may be feeling optimistic about the future direction of the share price.

See our latest analysis for McGrath

We don't have analyst forecasts, but you can see how recent trends are setting up the company for the future by checking out our free report on McGrath's earnings, revenue and cash flow.

Does Growth Match The Low P/E?

There's an inherent assumption that a company should underperform the market for P/E ratios like McGrath's to be considered reasonable.

Retrospectively, the last year delivered a frustrating 46% decrease to the company's bottom line. Still, the latest three year period has seen an excellent 802% overall rise in EPS, in spite of its unsatisfying short-term performance. Accordingly, while they would have preferred to keep the run going, shareholders would probably welcome the medium-term rates of earnings growth.

Comparing that to the market, which is only predicted to deliver 24% growth in the next 12 months, the company's momentum is stronger based on recent medium-term annualised earnings results.

With this information, we find it odd that McGrath is trading at a P/E lower than the market. Apparently some shareholders believe the recent performance has exceeded its limits and have been accepting significantly lower selling prices.

The Bottom Line On McGrath's P/E

Generally, our preference is to limit the use of the price-to-earnings ratio to establishing what the market thinks about the overall health of a company.

We've established that McGrath currently trades on a much lower than expected P/E since its recent three-year growth is higher than the wider market forecast. When we see strong earnings with faster-than-market growth, we assume potential risks are what might be placing significant pressure on the P/E ratio. At least price risks look to be very low if recent medium-term earnings trends continue, but investors seem to think future earnings could see a lot of volatility.

We don't want to rain on the parade too much, but we did also find 3 warning signs for McGrath (1 is concerning!) that you need to be mindful of.

Of course, you might also be able to find a better stock than McGrath. So you may wish to see this free collection of other companies that have reasonable P/E ratios and have grown earnings strongly.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.