Arch Capital Group Ltd.'s (NASDAQ:ACGL) price-to-earnings (or "P/E") ratio of 7.9x might make it look like a strong buy right now compared to the market in the United States, where around half of the companies have P/E ratios above 17x and even P/E's above 32x are quite common. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the highly reduced P/E.
Recent times have been pleasing for Arch Capital Group as its earnings have risen in spite of the market's earnings going into reverse. One possibility is that the P/E is low because investors think the company's earnings are going to fall away like everyone else's soon. If not, then existing shareholders have reason to be quite optimistic about the future direction of the share price.
Does Growth Match The Low P/E?
The only time you'd be truly comfortable seeing a P/E as depressed as Arch Capital Group's is when the company's growth is on track to lag the market decidedly.
If we review the last year of earnings growth, the company posted a terrific increase of 207%. The latest three year period has also seen an excellent 248% overall rise in EPS, aided by its short-term performance. So we can start by confirming that the company has done a great job of growing earnings over that time.
Turning to the outlook, the next three years should bring diminished returns, with earnings decreasing 8.4% each year as estimated by the ten analysts watching the company. That's not great when the rest of the market is expected to grow by 11% per year.
In light of this, it's understandable that Arch Capital Group's P/E would sit below the majority of other companies. However, shrinking earnings are unlikely to lead to a stable P/E over the longer term. Even just maintaining these prices could be difficult to achieve as the weak outlook is weighing down the shares.
The Key Takeaway
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 Arch Capital Group maintains its low P/E on the weakness of its forecast for sliding earnings, 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. 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 Arch Capital Group (at least 1 which shouldn't be ignored), 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 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.