Unfortunately for some shareholders, the RH (NYSE:RH) share price has dived 66% in the last thirty days. Indeed the recent decline has arguably caused some bitterness for shareholders who have held through the 38% drop over twelve months.

All else being equal, a share price drop should make a stock more 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). 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). 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?

RH’s P/E is 8.09. As you can see below RH has a P/E ratio that is fairly close for the average for the specialty retail industry, which is 8.1.

RH’s P/E tells us that market participants think its prospects are roughly in line with its industry. So if RH actually outperforms its peers going forward, that should be a positive for the share price. Further research into factors such as insider buying and selling, could help you form your own view on whether that is likely.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. When earnings grow, the ‘E’ increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

RH’s earnings made like a rocket, taking off 98% last year. The sweetener is that the annual five year growth rate of 39% is also impressive. So I’d be surprised if the P/E ratio was not above average.

Remember: P/E Ratios Don’t Consider The Balance Sheet

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. 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.

Is Debt Impacting RH’s P/E?

Net debt totals 62% of RH’s market cap. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.

The Bottom Line On RH’s P/E Ratio

RH has a P/E of 8.1. That’s below the average in the US market, which is 11.5. The company has a meaningful amount of debt on the balance sheet, but that should not eclipse the solid earnings growth. The low P/E ratio suggests current market expectations are muted, implying these levels of growth will not continue. What can be absolutely certain is that the market has become more pessimistic about RH over the last month, with the P/E ratio falling from 23.8 back then to 8.1 today. 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.

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.