Despite Its High P/E Ratio, Is Roots Corporation (TSE:ROOT) Still Undervalued?

Today, we’ll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we’ll show how Roots Corporation’s (TSE:ROOT) P/E ratio could help you assess the value on offer. Based on the last twelve months, Roots’s P/E ratio is 15.56. That corresponds to an earnings yield of approximately 6.4%.

View our latest analysis for Roots

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for Roots:

P/E of 15.56 = CA$2.67 ÷ CA$0.17 (Based on the trailing twelve months to May 2019.)

Is A High P/E Ratio Good?

A higher P/E ratio means that investors are paying a higher price for each CA$1 of company earnings. That isn’t a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business’s prospects, relative to stocks with a lower P/E.

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

The P/E ratio indicates whether the market has higher or lower expectations of a company. As you can see below, Roots has a higher P/E than the average company (12.5) in the specialty retail industry.

TSX:ROOT Price Estimation Relative to Market, September 3rd 2019
TSX:ROOT Price Estimation Relative to Market, September 3rd 2019

Roots’s P/E tells us that market participants think the company will perform better than its industry peers, going forward.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Roots’s earnings per share fell by 58% in the last twelve months.

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. 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 expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

Roots’s Balance Sheet

Roots’s net debt is 100% of its market cap. This is enough debt that you’d have to make some adjustments before using the P/E ratio to compare it to a company with net cash.

The Bottom Line On Roots’s P/E Ratio

Roots’s P/E is 15.6 which is above average (14) in its market. With significant debt and no EPS growth last year, shareholders are betting on an improvement in earnings from the company.

When the market is wrong about a stock, it gives savvy investors an opportunity. 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.

You might be able to find a better buy than Roots. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

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.