Unfortunately for some shareholders, the adidas (ETR:ADS) share price has dived 39% in the last thirty days. Even longer term holders have taken a real hit with the stock declining 18% in the last year.
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). So, on certain occasions, long term focussed investors try to take advantage of pessimistic expectations to buy shares at a better price. 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 adidas Have A Relatively High Or Low P/E For Its Industry?
adidas has a P/E ratio of 18.87. The image below shows that adidas has a P/E ratio that is roughly in line with the luxury industry average (18.9).
That indicates that the market expects adidas will perform roughly in line with other companies in its industry. If the company has better than average prospects, then the market might be underestimating it. I would further inform my view by checking insider buying and selling., among other things.
How Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. And in that case, the P/E ratio itself will drop rather quickly. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Most would be impressed by adidas earnings growth of 16% in the last year. And earnings per share have improved by 26% annually, over the last five years. With that performance, you might expect an above average P/E ratio.
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. In other words, it does not consider any debt or cash that the company may have on the balance sheet. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
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.
How Does adidas's Debt Impact Its P/E Ratio?
adidas has net cash of €1.0b. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Verdict On adidas's P/E Ratio
adidas's P/E is 18.9 which is above average (16.8) in its market. Its net cash position supports a higher P/E ratio, as does its solid recent earnings growth. So it is not surprising the market is probably extrapolating recent growth well into the future, reflected in the relatively high P/E ratio. What can be absolutely certain is that the market has become significantly less optimistic about adidas over the last month, with the P/E ratio falling from 31.1 back then to 18.9 today. 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 have an opportunity when market expectations about a stock are wrong. 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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
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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