Essential Metals Limited (ASX:ESS) shares have had a really impressive month, gaining 34% after a shaky period beforehand. Unfortunately, the gains of the last month did little to right the losses of the last year with the stock still down 35% over that time.
Although its price has surged higher, given close to half the companies in Australia have price-to-earnings ratios (or "P/E's") above 21x, you may still consider Essential Metals as an attractive investment with its 14.4x P/E ratio. However, the P/E might be low for a reason and it requires further investigation to determine if it's justified.
Essential Metals certainly has been doing a great job lately as it's been growing earnings at a really rapid pace. One possibility is that the P/E is low because investors think this strong earnings growth might actually underperform the broader market in the near future. If that doesn't eventuate, then existing shareholders have reason to be quite optimistic about the future direction of the share price.
Although there are no analyst estimates available for Essential Metals, take a look at this free data-rich visualisation to see how the company stacks up on earnings, revenue and cash flow.
How Is Essential Metals' Growth Trending?
There's an inherent assumption that a company should underperform the market for P/E ratios like Essential Metals' to be considered reasonable.
Taking a look back first, we see that the company grew earnings per share by an impressive 375% last year. However, the latest three year period hasn't been as great in aggregate as it didn't manage to provide any growth at all. Therefore, it's fair to say that earnings growth has been inconsistent recently for the company.
Weighing that recent medium-term earnings trajectory against the broader market's one-year forecast for expansion of 22% shows it's noticeably less attractive on an annualised basis.
In light of this, it's understandable that Essential Metals' P/E sits below the majority of other companies. Apparently many shareholders weren't comfortable holding on to something they believe will continue to trail the bourse.
The Key Takeaway
The latest share price surge wasn't enough to lift Essential Metals' P/E close to the market median. It's argued the price-to-earnings ratio is an inferior measure of value within certain industries, but it can be a powerful business sentiment indicator.
We've established that Essential Metals maintains its low P/E on the weakness of its recentthree-year growth being lower than the wider market forecast, as expected. At this stage investors feel the potential for an improvement in earnings isn't great enough to justify a higher P/E ratio. If recent medium-term earnings trends continue, it's hard to see the share price rising strongly in the near future under these circumstances.
It's always necessary to consider the ever-present spectre of investment risk. We've identified 2 warning signs with Essential Metals, and understanding these should be part of your investment process.
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 a strong growth track record, trading on a P/E below 20x.
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. 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.
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