To the annoyance of some shareholders, RaySearch Laboratories (STO:RAY B) shares are down a considerable 35% in the last month. Indeed the recent decline has arguably caused some bitterness for shareholders who have held through the 47% drop over 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). The implication here is that long term investors have an opportunity when expectations of a company are too low. One way to gauge market expectations of a stock is to look at its Price to Earnings Ratio (PE Ratio). A high P/E implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.
Does RaySearch Laboratories Have A Relatively High Or Low P/E For Its Industry?
We can tell from its P/E ratio of 37.41 that there is some investor optimism about RaySearch Laboratories. As you can see below, RaySearch Laboratories has a higher P/E than the average company (34.3) in the healthcare services industry.
That means that the market expects RaySearch Laboratories will outperform other companies in its industry. The market is optimistic about the future, but that doesn’t guarantee future growth. So further research is always essential. I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
When earnings fall, the ‘E’ decreases, over time. That means unless the share price falls, the P/E will increase in a few years. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
RaySearch Laboratories saw earnings per share decrease by 36% last year. And EPS is down 3.4% a year, over the last 5 years. This might lead to muted expectations.
Remember: P/E Ratios Don’t Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. 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 investing in growth. That means taking on debt (or spending its cash).
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 RaySearch Laboratories’s Balance Sheet Tell Us?
The extra options and safety that comes with RaySearch Laboratories’s kr64m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Verdict On RaySearch Laboratories’s P/E Ratio
RaySearch Laboratories’s P/E is 37.4 which is above average (14.4) in its market. The recent drop in earnings per share would make some investors cautious, but the relatively strong balance sheet will allow the company time to invest in growth. Clearly, the high P/E indicates shareholders think it will! Given RaySearch Laboratories’s P/E ratio has declined from 57.5 to 37.4 in the last month, we know for sure that the market is significantly less confident about the business today, than it was back then. For those who prefer to invest with the flow of momentum, that might be a bad sign, but for a contrarian, it may signal opportunity.
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 visual report on analyst forecasts could hold the key to an excellent investment decision.
You might be able to find a better buy than RaySearch Laboratories. 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).
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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