Here’s How P/E Ratios Can Help Us Understand Roots Corporation (TSE:ROOT)

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We’ll show how you can use Roots Corporation’s (TSE:ROOT) P/E ratio to inform your assessment of the investment opportunity. Roots has a price to earnings ratio of 8.98, based on the last twelve months. That means that at current prices, buyers pay CA$8.98 for every CA$1 in trailing yearly profits.

Check out our latest analysis for Roots

How Do I Calculate A Price To Earnings Ratio?

The formula for P/E is:

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

Or for Roots:

P/E of 8.98 = CA$2.99 ÷ CA$0.33 (Based on the trailing twelve months to November 2018.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each CA$1 the company has earned over the last year. That isn’t necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.

How Growth Rates Impact P/E Ratios

Companies that shrink earnings per share quickly will rapidly decrease the ‘E’ in the equation. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. Then, a higher P/E might scare off shareholders, pushing the share price down.

Roots maintained roughly steady earnings over the last twelve months. And EPS is down 7.1% a year, over the last 3 years. So you wouldn’t expect a very high P/E.

How Does Roots’s P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Roots has a lower P/E than the average (11.7) P/E for companies in the specialty retail industry.

TSX:ROOT PE PEG Gauge December 26th 18
TSX:ROOT PE PEG Gauge December 26th 18

This suggests that market participants think Roots will underperform other companies in its industry. Many investors like to buy stocks when the market is pessimistic about their prospects. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

The ‘Price’ in P/E reflects the market capitalization of the company. That means it doesn’t take debt or cash into account. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining 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.

Is Debt Impacting Roots’s P/E?

Roots’s net debt is considerable, at 102% of its market cap. This is a relatively high level of debt, so the stock probably deserves a relatively low P/E ratio. Keep that in mind when comparing it to other companies.

The Verdict On Roots’s P/E Ratio

Roots trades on a P/E ratio of 9, which is below the CA market average of 13. The P/E reflects market pessimism that probably arises from the lack of recent EPS growth, paired with significant leverage.

Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. 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).

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.