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Do You Like Terra Firma Capital Corporation (CVE:TII) At This P/E Ratio?

Simply Wall St

Terra Firma Capital (CVE:TII) shares have retraced a considerable in the last month. But there's still good reason for shareholders to be content; the stock has gained 8.0% in the last 90 days. The stock has been solid, longer term, gaining 23% in the last year.

Assuming no other changes, a sharply higher share price makes a stock less attractive to potential buyers. 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 deep value investors might steer clear when expectations of a company are too high. One way to gauge market expectations of a stock 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.

See our latest analysis for Terra Firma Capital

Does Terra Firma Capital Have A Relatively High Or Low P/E For Its Industry?

Terra Firma Capital's P/E of 6.55 indicates relatively low sentiment towards the stock. The image below shows that Terra Firma Capital has a lower P/E than the average (11.8) P/E for companies in the mortgage industry.

TSXV:TII Price Estimation Relative to Market, February 21st 2020

Terra Firma Capital's P/E tells us that market participants think it will not fare as well as its peers in the same industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. Earnings growth means that in the future the 'E' will be higher. 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.

Terra Firma Capital's earnings made like a rocket, taking off 346% last year. And earnings per share have improved by 22% annually, over the last three years. So we'd absolutely expect it to have a relatively high P/E ratio. Regrettably, the longer term performance is poor, with EPS down 3.8% per year over 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. So it won't reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

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).

Terra Firma Capital's Balance Sheet

Net debt totals a substantial 369% of Terra Firma Capital's market cap. If you want to compare its P/E ratio to other companies, you must keep in mind that these debt levels would usually warrant a relatively low P/E.

The Bottom Line On Terra Firma Capital's P/E Ratio

Terra Firma Capital trades on a P/E ratio of 6.5, which is below the CA market average of 16.0. The company may have significant debt, but EPS growth was good last year. If it continues to grow, then the current low P/E may prove to be unjustified. What can be absolutely certain is that the market has become more pessimistic about Terra Firma Capital over the last month, with the P/E ratio falling from 6.5 back then to 6.5 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 have an opportunity when market expectations about a stock are wrong. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

Of course you might be able to find a better stock than Terra Firma Capital. So you may wish to see this free collection of other companies that have grown earnings strongly.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.