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A Rising Share Price Has Us Looking Closely At ASOS Plc's (LON:ASC) P/E Ratio

Simply Wall St

ASOS (LON:ASC) shareholders are no doubt pleased to see that the share price has bounced 119% in the last month alone, although it is still down 28% over the last quarter. But shareholders may not all be feeling jubilant, since the share price is still down 41% in the last year.

Assuming no other changes, a sharply higher share price makes a stock less 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 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). Investors have optimistic expectations of companies with higher P/E ratios, compared to companies with lower P/E ratios.

See our latest analysis for ASOS

Does ASOS Have A Relatively High Or Low P/E For Its Industry?

ASOS's P/E of 43.02 indicates some degree of optimism towards the stock. You can see in the image below that the average P/E (19.6) for companies in the online retail industry is lower than ASOS's P/E.

AIM:ASC Price Estimation Relative to Market April 17th 2020

That means that the market expects ASOS will outperform other companies in its industry. 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. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. 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.

ASOS shrunk earnings per share by 27% over the last year. But EPS is up 4.2% over the last 5 years.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

Don't forget that the P/E ratio considers market capitalization. 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).

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.

ASOS's Balance Sheet

Net debt totals just 7.1% of ASOS's market cap. So it doesn't have as many options as it would with net cash, but its debt would not have much of an impact on its P/E ratio.

The Bottom Line On ASOS's P/E Ratio

ASOS has a P/E of 43.0. That's significantly higher than the average in its market, which is 13.3. With some debt but no EPS growth last year, the market has high expectations of future profits. What is very clear is that the market has become significantly more optimistic about ASOS over the last month, with the P/E ratio rising from 19.6 back then to 43.0 today. If you like to buy stocks that have recently impressed the market, then this one might be a candidate; but if you prefer to invest when there is 'blood in the streets', then you may feel the opportunity has passed.

When the market is wrong about a stock, it gives savvy investors an opportunity. 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 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 editorial-team@simplywallst.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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.