When close to half the companies in the United States have price-to-earnings ratios (or "P/E's") above 19x, you may consider SM Energy Company (NYSE:SM) as a highly attractive investment with its 5x P/E ratio. However, the P/E might be quite low for a reason and it requires further investigation to determine if it's justified.
Recent times have been advantageous for SM Energy as its earnings have been rising faster than most other companies. One possibility is that the P/E is low because investors think this strong earnings performance might be less impressive moving forward. If not, then existing shareholders have reason to be quite optimistic about the future direction of the share price.
What Are Growth Metrics Telling Us About The Low P/E?
There's an inherent assumption that a company should far underperform the market for P/E ratios like SM Energy's to be considered reasonable.
Taking a look back first, we see that the company managed to grow earnings per share by a handy 4.5% last year. Although, the latest three year period in total hasn't been as good as it didn't manage to provide any growth at all. Accordingly, shareholders probably wouldn't have been overly satisfied with the unstable medium-term growth rates.
Looking ahead now, EPS is anticipated to slump, contracting by 0.3% during the coming year according to the ten analysts following the company. Meanwhile, the broader market is forecast to expand by 15%, which paints a poor picture.
With this information, we are not surprised that SM Energy is trading at a P/E lower than the market. Nonetheless, there's no guarantee the P/E has reached a floor yet with earnings going in reverse. There's potential for the P/E to fall to even lower levels if the company doesn't improve its profitability.
The Final Word
Generally, our preference is to limit the use of the price-to-earnings ratio to establishing what the market thinks about the overall health of a company.
As we suspected, our examination of SM Energy's analyst forecasts revealed that its outlook for shrinking earnings is contributing to its low P/E. At this stage investors feel the potential for an improvement in earnings isn't great enough to justify a higher P/E ratio. Unless these conditions improve, they will continue to form a barrier for the share price around these levels.
The company's balance sheet is another key area for risk analysis. Take a look at our free balance sheet analysis for SM Energy with six simple checks on some of these key factors.
It's important to make sure you look for a great company, not just the first idea you come across. So take a peek at this free list of interesting companies with strong recent earnings growth (and a low P/E).
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
