Fortescue Metals Group (ASX:FMG) shares have had a really impressive month, gaining 31%, after some slippage. And the full year gain of 38% isn't too shabby, either!
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). The implication here is that deep value investors might steer clear when expectations of a company are too high. 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.
Does Fortescue Metals Group Have A Relatively High Or Low P/E For Its Industry?
We can tell from its P/E ratio of 4.29 that sentiment around Fortescue Metals Group isn't particularly high. If you look at the image below, you can see Fortescue Metals Group has a lower P/E than the average (8.4) in the metals and mining industry classification.
This suggests that market participants think Fortescue Metals Group will underperform other companies in its industry. 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
Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the 'E' will be higher. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.
Fortescue Metals Group's 498% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. The cherry on top is that the five year growth rate was an impressive 30% per year. So I'd be surprised if the P/E ratio was not above average.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. So it won't reflect the advantage of cash, or disadvantage of debt. 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.
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 Fortescue Metals Group's Balance Sheet Tell Us?
Fortescue Metals Group has net cash of US$110m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Bottom Line On Fortescue Metals Group's P/E Ratio
Fortescue Metals Group's P/E is 4.3 which is below average (13.4) in the AU market. The net cash position gives plenty of options to the business, and the recent improvement in EPS is good to see. The below average P/E ratio suggests that market participants don't believe the strong growth will continue. What we know for sure is that investors are becoming less uncomfortable about Fortescue Metals Group's prospects, since they have pushed its P/E ratio from 3.3 to 4.3 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.
When the market is wrong about a stock, it gives savvy investors an opportunity. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. 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: Fortescue Metals Group 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 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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