To the annoyance of some shareholders, NVR (NYSE:NVR) shares are down a considerable 42% in the last month. The recent drop has obliterated the annual return, with the share price now down 15% over that longer period.
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). A high P/E implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.
How Does NVR's P/E Ratio Compare To Its Peers?
We can tell from its P/E ratio of 9.62 that there is some investor optimism about NVR. You can see in the image below that the average P/E (8.1) for companies in the consumer durables industry is lower than NVR's P/E.
That means that the market expects NVR will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So investors 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. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. And in that case, the P/E ratio itself will drop rather quickly. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
NVR's earnings per share grew by 9.9% in the last twelve months. And it has bolstered its earnings per share by 30% per year over the last five years.
Remember: P/E Ratios Don't Consider The Balance Sheet
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. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
So What Does NVR's Balance Sheet Tell Us?
Since NVR holds net cash of US$513m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On NVR's P/E Ratio
NVR's P/E is 9.6 which is below average (12.7) in the US market. Earnings improved over the last year. Also positive, the relatively strong balance sheet will allow for investment in growth. In contrast, the P/E indicates shareholders doubt that will happen! What can be absolutely certain is that the market has become more pessimistic about NVR over the last month, with the P/E ratio falling from 16.6 back then to 9.6 today. For those who prefer invest in growth, this stock apparently offers limited promise, but the deep value investors may find the pessimism around this stock enticing.
Investors should be looking to buy stocks that the market is wrong about. 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. 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.
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