Barratt Developments (LON:BDEV) shareholders are no doubt pleased to see that the share price has bounced 38% in the last month alone, although it is still down 35% over the last quarter. But shareholders may not all be feeling jubilant, since the share price is still down 11% in the last year.
All else being equal, a sharp share price increase should make a stock less attractive to potential investors. 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 some would prefer to hold off buying when there is a lot of optimism towards a stock. 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). A high P/E ratio means that investors have a high expectation about future growth, while a low P/E ratio means they have low expectations about future growth.
How Does Barratt Developments's P/E Ratio Compare To Its Peers?
We can tell from its P/E ratio of 7.14 that sentiment around Barratt Developments isn't particularly high. The image below shows that Barratt Developments has a lower P/E than the average (8.3) P/E for companies in the consumer durables industry.
Its relatively low P/E ratio indicates that Barratt Developments shareholders think it will struggle to do as well as other companies in its industry classification. Many investors like to buy stocks when the market is pessimistic about their prospects. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. 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. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Barratt Developments's earnings per share grew by 3.0% in the last twelve months. And earnings per share have improved by 14% annually, 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. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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.
Is Debt Impacting Barratt Developments's P/E?
Barratt Developments has net cash of UK£427m. 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 Barratt Developments's P/E Ratio
Barratt Developments trades on a P/E ratio of 7.1, which is below the GB market average of 14.1. Earnings improved over the last year. Also positive, the relatively strong balance sheet will allow for investment in growth. In contrast, the P/E indicates shareholders doubt that will happen! What we know for sure is that investors are becoming less uncomfortable about Barratt Developments's prospects, since they have pushed its P/E ratio from 5.2 to 7.1 over the last month. For those who like to invest in turnarounds, that might mean it's time to put the stock on a watchlist, or research it. But others might consider the opportunity to have passed.
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.
But note: Barratt Developments may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio 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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