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West African Resources Limited's (ASX:WAF) price-to-earnings (or "P/E") ratio of 6.5x might make it look like a strong buy right now compared to the market in Australia, where around half of the companies have P/E ratios above 17x and even P/E's above 32x are quite common. 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 West African Resources as its earnings have been rising faster than most other companies. It might be that many expect the strong earnings performance to degrade substantially, 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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Is There Any Growth For West African Resources?
There's an inherent assumption that a company should far underperform the market for P/E ratios like West African Resources' to be considered reasonable.
Taking a look back first, we see that the company grew earnings per share by an impressive 105% last year. Still, EPS has barely risen at all from three years ago in total, which is not ideal. Therefore, it's fair to say that earnings growth has been inconsistent recently for the company.
Looking ahead now, EPS is anticipated to slump, contracting by 12% per year during the coming three years according to the two analysts following the company. Meanwhile, the broader market is forecast to expand by 14% per annum, which paints a poor picture.
With this information, we are not surprised that West African Resources 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. Even just maintaining these prices could be difficult to achieve as the weak outlook is weighing down the shares.
What We Can Learn From West African Resources' 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.
We've established that West African Resources 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. Unless these conditions improve, they will continue to form a barrier for the share price around these levels.