The Halfords (LSE: HFD) share price has exploded, up 17{429fc2506e610357e12b2a5665db82631200a2e00b3a1d8839077d76f18e2e8b} over the last month. Indeed, shares in the automotive, leisure, and cycling product retailer leave the FTSE All-Share‘s comparative 0.75{429fc2506e610357e12b2a5665db82631200a2e00b3a1d8839077d76f18e2e8b} return looking fairly dismal.
In addition, many analysts appear to be positive about the company as more people cycling means higher revenues. I’m seeing quite a few buy recommendations across the Internet and these likely explain the recent good stock performance.
However, looking more closely, many of these analysts are valuing the stock using forward price-to-earnings (P/E) ratios. In my mind, this is nonsensical and makes me question the sanity of the share price, especially when car use is currently low.
The problem with forward P/E ratios
A forward P/E ratio is calculated by dividing the current known price by next year’s predicted earnings. I’ve seen forward P/E ratios for the Halfords share price that vary from 9 to 17. And there’s probably more outliers out there too.
The problem, of course, is that what Halfords will earn next year is anybody’s guess. And that’s all it is. The forward P/E ratio is based on an estimate of Halfords’ future business. And, with a huge variance from one analyst to the next.
Now, you could argue that these forward P/Es are all relatively low, especially when compared with the specialist retail sector’s average P/E of around 24. So, what’s the problem?
The problem is Halfords’ actual recorded figures. Taking an average of the last five years of earnings for the company, I calculated average normalised earnings of 28p per share. This figure gives an average P/E of around 6.8, lower than all the forward P/E ratios I’ve seen reported.
Consequently, it appears that, far from being confident in Halfords’ future, analysts are expecting earnings to drop.
Halfords share price will follow its earnings
The problem, of course, with lower earnings from one year to the next is the share price will likely follow. And Halfords has reported a declining trend in earnings over the last five years that parallels the share price trend.
Although turnover has increased each year since 2016, operating profit has dropped year on year. Sadly for Halfords, it looked like it was about to buck this trend this year when Covid-19 struck. Dividend payments on top of closure costs resulted in an overall loss for the year.
On the bright side, the uptake in cycling during lockdown helped to offset the impact of lowering car use on Halfords’ 2020 finances. But the motoring business is higher margin than cycling and Halfords will need to adjust its business model to fit.
When combined with a troubling economic outlook overall, there is significant uncertainty about Halfords’ immediate future.
At current levels, Halfords shares aren’t badly priced. But, buying a stock based on a P/E ratio using unknown future earnings is highly risky. I think Halfords will continue its downward trend, certainly in the short term. So, for the moment, I’m out.
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Rachael FitzGerald-Finch has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
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