Unfortunately for some shareholders, the Albemarle (NYSE:ALB) share price has dived 43% in the last thirty days. Indeed the recent decline has arguably caused some bitterness for shareholders who have held through the 35% 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. 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.
Does Albemarle Have A Relatively High Or Low P/E For Its Industry?
We can tell from its P/E ratio of 10.62 that sentiment around Albemarle isn’t particularly high. We can see in the image below that the average P/E (13.6) for companies in the chemicals industry is higher than Albemarle’s P/E.
Albemarle’s P/E tells us that market participants think it will not fare as well as its peers in the same industry. Many investors like to buy stocks when the market is pessimistic about their prospects.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Albemarle shrunk earnings per share by 21% over the last year. But EPS is up 14% over the last 5 years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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).
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
How Does Albemarle’s Debt Impact Its P/E Ratio?
Albemarle has net debt equal to 42% of its market cap. You’d want to be aware of this fact, but it doesn’t bother us.
The Verdict On Albemarle’s P/E Ratio
Albemarle trades on a P/E ratio of 10.6, which is below the US market average of 11.8. Since it only carries a modest debt load, it’s likely the low expectations implied by the P/E ratio arise from the lack of recent earnings growth. Given Albemarle’s P/E ratio has declined from 18.7 to 10.6 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 don’t like to trade against momentum, that could be a warning sign, but a contrarian investor might want to take a closer look.