To the annoyance of some shareholders, Westpac Banking (ASX:WBC) shares are down a considerable 30% in the last month. That drop has capped off a tough year for shareholders, with the share price down 39% in that time.
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. 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 Westpac Banking's P/E Ratio Compare To Its Peers?
Westpac Banking has a P/E ratio of 8.13. The image below shows that Westpac Banking has a P/E ratio that is roughly in line with the banks industry average (7.9).
Its P/E ratio suggests that Westpac Banking shareholders think that in the future it will perform about the same as other companies in its industry classification. If the company has better than average prospects, then the market might be underestimating it. Checking factors such as director buying and selling. could help you form your own view on if that will happen.
How Growth Rates Impact P/E Ratios
If earnings fall then in the future the 'E' will be lower. That means even if the current P/E is low, it will increase over time if the share price stays flat. Then, a higher P/E might scare off shareholders, pushing the share price down.
Westpac Banking shrunk earnings per share by 17% over the last year. And EPS is down 4.1% a year, over the last 5 years. This might lead to muted expectations.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
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. 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 expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
So What Does Westpac Banking's Balance Sheet Tell Us?
Westpac Banking's net debt is considerable, at 272% of its market cap. This is a relatively high level of debt, so the stock probably deserves a relatively low P/E ratio. Keep that in mind when comparing it to other companies.
The Verdict On Westpac Banking's P/E Ratio
Westpac Banking trades on a P/E ratio of 8.1, which is below the AU market average of 13.4. The P/E reflects market pessimism that probably arises from the lack of recent EPS growth, paired with significant leverage. Given Westpac Banking's P/E ratio has declined from 11.7 to 8.1 in the last month, we know for sure that the market is more worried 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 deep value investors this stock might justify some research.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. 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.
You might be able to find a better buy than Westpac Banking. 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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