Unfortunately for some shareholders, the General Dynamics (NYSE:GD) share price has dived 33% in the last thirty days. Even longer term holders have taken a real hit with the stock declining 26% in the last year.
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. 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). Investors have optimistic expectations of companies with higher P/E ratios, compared to companies with lower P/E ratios.
How Does General Dynamics's P/E Ratio Compare To Its Peers?
We can tell from its P/E ratio of 10.48 that sentiment around General Dynamics isn't particularly high. We can see in the image below that the average P/E (13.2) for companies in the aerospace & defense industry is higher than General Dynamics's P/E.
This suggests that market participants think General Dynamics will underperform other companies in its industry. Since the market seems unimpressed with General Dynamics, it's quite possible it could surprise on the upside. You 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. When earnings grow, the 'E' increases, over time. That means unless the share price increases, the P/E will reduce in a few years. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
General Dynamics's earnings per share grew by 6.3% in the last twelve months. And earnings per share have improved by 8.7% annually, over the last five years.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. That means it doesn't take debt or cash into account. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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 General Dynamics's Balance Sheet Tell Us?
General Dynamics has net debt equal to 30% of its market cap. You'd want to be aware of this fact, but it doesn't bother us.
The Bottom Line On General Dynamics's P/E Ratio
General Dynamics trades on a P/E ratio of 10.5, which is below the US market average of 12.7. The company hasn't stretched its balance sheet, and earnings are improving. If you believe growth will continue - or even increase - then the low P/E may signify opportunity. Given General Dynamics's P/E ratio has declined from 15.6 to 10.5 in the last month, we know for sure that the market is significantly less confident about the business today, than it was back then. 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.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.
You might be able to find a better buy than General Dynamics. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
If you spot an error that warrants correction, please contact the editor at email@example.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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