To the annoyance of some shareholders, Yelp (NYSE:YELP) shares are down a considerable 37% in the last month. Indeed the recent decline has arguably caused some bitterness for shareholders who have held through the 39% 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. Perhaps the simplest way to get a read on investors’ expectations of a business is to look at its Price to Earnings Ratio (PE Ratio). Investors have optimistic expectations of companies with higher P/E ratios, compared to companies with lower P/E ratios.
How Does Yelp’s P/E Ratio Compare To Its Peers?
We can tell from its P/E ratio of 38.44 that there is some investor optimism about Yelp. The image below shows that Yelp has a higher P/E than the average (22.2) P/E for companies in the interactive media and services industry.
Yelp’s P/E tells us that market participants think the company will perform better than its industry peers, going forward. 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.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company’s P/E multiple. When earnings grow, the ‘E’ increases, over time. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Yelp’s earnings per share fell by 17% in the last twelve months. But it has grown its earnings per share by 1.6% per year over the last five years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. Thus, the metric does not reflect cash or debt held by the company. 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).
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
So What Does Yelp’s Balance Sheet Tell Us?
With net cash of US$412m, Yelp has a very strong balance sheet, which may be important for its business. Having said that, at 27% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On Yelp’s P/E Ratio
Yelp’s P/E is 38.4 which is way above average (12.6) 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 Yelp’s P/E ratio has declined from 61.2 to 38.4 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 don’t like to trade against momentum, that could be a warning sign, but a contrarian investor might want to take a closer look.
Investors have an opportunity when market expectations about a stock are wrong. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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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