Unfortunately for some shareholders, the Elementis (LON:ELM) share price has dived 35% in the last thirty days. Indeed the recent decline has arguably caused some bitterness for shareholders who have held through the 45% drop over twelve months.
All else being equal, a share price drop should make a stock more attractive to potential investors. While the market sentiment towards a stock is very changeable, in the long run, the share price will tend to move in the same direction as earnings per share. 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). Investors have optimistic expectations of companies with higher P/E ratios, compared to companies with lower P/E ratios.
How Does Elementis's P/E Ratio Compare To Its Peers?
Elementis's P/E of 13.60 indicates relatively low sentiment towards the stock. We can see in the image below that the average P/E (17.8) for companies in the chemicals industry is higher than Elementis's P/E.
Its relatively low P/E ratio indicates that Elementis 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. You should delve deeper. I like to check if company insiders have been buying or 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. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.
Elementis shrunk earnings per share by 16% over the last year. And over the longer term (5 years) earnings per share have decreased 27% annually. This might lead to muted expectations.
Remember: P/E Ratios Don't Consider The Balance Sheet
The 'Price' in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. 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.
So What Does Elementis's Balance Sheet Tell Us?
Net debt totals 71% of Elementis's market cap. This is enough debt that you'd have to make some adjustments before using the P/E ratio to compare it to a company with net cash.
The Bottom Line On Elementis's P/E Ratio
Elementis trades on a P/E ratio of 13.6, which is below the GB market average of 15.1. The P/E reflects market pessimism that probably arises from the lack of recent EPS growth, paired with significant leverage. What can be absolutely certain is that the market has become significantly less optimistic about Elementis over the last month, with the P/E ratio falling from 21.0 back then to 13.6 today. 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 it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
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 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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