To the annoyance of some shareholders, Builders FirstSource (NASDAQ:BLDR) shares are down a considerable 59% in the last month. The recent drop has obliterated the annual return, with the share price now down 9.0% over that longer period.
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. So, on certain occasions, long term focussed investors try to take advantage of pessimistic expectations to buy shares at a better price. 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.
How Does Builders FirstSource's P/E Ratio Compare To Its Peers?
We can tell from its P/E ratio of 5.96 that sentiment around Builders FirstSource isn't particularly high. If you look at the image below, you can see Builders FirstSource has a lower P/E than the average (15.5) in the building industry classification.
Builders FirstSource'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. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. When earnings grow, the 'E' increases, over time. 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.
Builders FirstSource's earnings per share grew by 7.0% in the last twelve months. And earnings per share have improved by 60% annually, over the last five years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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).
Is Debt Impacting Builders FirstSource's P/E?
Builders FirstSource has net debt worth 95% of its market capitalization. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.
The Verdict On Builders FirstSource's P/E Ratio
Builders FirstSource's P/E is 6.0 which is below average (11.8) in the US market. The meaningful debt load is probably contributing to low expectations, even though it has improved earnings recently. What can be absolutely certain is that the market has become more pessimistic about Builders FirstSource over the last month, with the P/E ratio falling from 14.7 back then to 6.0 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. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. 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 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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