With a price-to-earnings (or "P/E") ratio of 2.3x AA plc (LON:AA.) may be sending very bullish signals at the moment, given that almost half of all companies in the United Kingdom have P/E ratios greater than 16x and even P/E's higher than 32x are not unusual. However, the P/E might be quite low for a reason and it requires further investigation to determine if it's justified.
With its earnings growth in positive territory compared to the declining earnings of most other companies, AA has been doing quite well of late. It might be that many expect the strong earnings performance to degrade substantially, possibly more than the market, which has repressed the P/E. If not, then existing shareholders have reason to be quite optimistic about the future direction of the share price.
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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 AA's to be considered reasonable.
Retrospectively, the last year delivered an exceptional 106% gain to the company's bottom line. The latest three year period has also seen a 16% overall rise in EPS, aided extensively by its short-term performance. So we can start by confirming that the company has actually done a good job of growing earnings over that time.
Looking ahead now, EPS is anticipated to slump, contracting by 9.0% each year during the coming three years according to the two analysts following the company. With the market predicted to deliver 12% growth per annum, that's a disappointing outcome.
With this information, we are not surprised that AA is trading at a P/E lower than the market. However, shrinking earnings are unlikely to lead to a stable P/E over the longer term. There's potential for the P/E to fall to even lower levels if the company doesn't improve its profitability.
The Bottom Line On AA's P/E
Typically, we'd caution against reading too much into price-to-earnings ratios when settling on investment decisions, though it can reveal plenty about what other market participants think about the company.
As we suspected, our examination of AA'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.