To the annoyance of some shareholders, RH (NYSE:RH) shares are down a considerable 32% in the last month. Looking back further, the stock is up 4.1% in the last year.
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. 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.
Does RH Have A Relatively High Or Low P/E For Its Industry?
We can tell from its P/E ratio of 14.87 that there is some investor optimism about RH. As you can see below, RH has a higher P/E than the average company (11.7) in the specialty retail industry.
That means that the market expects RH will outperform other companies in its industry. Clearly the market expects growth, but it isn’t guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
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. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
RH’s 98% 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 39% 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
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won’t reflect the advantage of cash, or disadvantage of debt. 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 spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
Is Debt Impacting RH’s P/E?
Net debt is 34% of RH’s market cap. While that’s enough to warrant consideration, it doesn’t really concern us.
The Verdict On RH’s P/E Ratio
RH’s P/E is 14.9 which is about average (15.1) in the US market. With only modest debt levels, and strong earnings growth, the market seems to doubt that the growth can be maintained. Since analysts are predicting growth will continue, one might expect to see a higher P/E so it may be worth looking closer. Given RH’s P/E ratio has declined from 21.7 to 14.9 in the last month, we know for sure that the market is significantly less confident 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 a contrarian, it may signal opportunity.
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.