To the annoyance of some shareholders, Auto Trader Group (LON:AUTO) shares are down a considerable 30% in the last month. The recent drop has obliterated the annual return, with the share price now down 18% over that longer period.

Assuming nothing else has changed, a lower share price makes a stock more 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. 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.

View our latest analysis for Auto Trader Group

Does Auto Trader Group Have A Relatively High Or Low P/E For Its Industry?

Auto Trader Group’s P/E is 18.43. You can see in the image below that the average P/E (19.8) for companies in the interactive media and services industry is roughly the same as Auto Trader Group’s P/E.

LSE:AUTO Price Estimation Relative to Market, March 17th 2020
LSE:AUTO Price Estimation Relative to Market, March 17th 2020

Auto Trader Group’s P/E tells us that market participants think its prospects are roughly in line with its industry. So if Auto Trader Group 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.

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How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. 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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

It’s great to see that Auto Trader Group grew EPS by 19% in the last year. And it has improved its earnings per share by 16% per year over the last three years. With that performance, you might expect an above average P/E ratio.

Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits

The ‘Price’ in P/E reflects the market capitalization of the company. So it won’t reflect the advantage of cash, or disadvantage of debt. 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 spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.

So What Does Auto Trader Group’s Balance Sheet Tell Us?

Auto Trader Group’s net debt is 7.8% of its market cap. So it doesn’t have as many options as it would with net cash, but its debt would not have much of an impact on its P/E ratio.

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The Bottom Line On Auto Trader Group’s P/E Ratio

Auto Trader Group trades on a P/E ratio of 18.4, which is above its market average of 12.5. The company is not overly constrained by its modest debt levels, and its recent EPS growth very solid. So on this analysis it seems reasonable that its P/E ratio is above average. What can be absolutely certain is that the market has become significantly less optimistic about Auto Trader Group over the last month, with the P/E ratio falling from 26.4 back then to 18.4 today. 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.

Investors have an opportunity when market expectations about a stock are wrong. 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.

But note: Auto Trader Group may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

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.

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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.



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