The Eastern Company (NASDAQ:EML) is currently trading at a trailing P/E of 22.4x, which is lower than the industry average of 27.4x. While this makes EML appear like a great stock to buy, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will explain what the P/E ratio is as well as what you should look out for when using it. See our latest analysis for EML
What you need to know about the P/E ratio
P/E is a popular ratio used for relative valuation. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for EML
Price-Earnings Ratio = Price per share ÷ Earnings per share
EML Price-Earnings Ratio = 28.7 ÷ 1.284 = 22.4x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as EML, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use. At 22.4x, EML’s P/E is lower than its industry peers (27.4x). This implies that investors are undervaluing each dollar of EML’s earnings. Therefore, according to this analysis, EML is an under-priced stock.
A few caveats
However, before you rush out to buy EML, it is important to note that this conclusion is based on two key assumptions. The first is that our “similar companies” are actually similar to EML, or else the difference in P/E might be a result of other factors. For example, if you compared lower risk firms with EML, then investors would naturally value it at a lower price since it is a riskier investment. The second assumption that must hold true is that the stocks we are comparing EML to are fairly valued by the market. If this does not hold true, EML’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Are you a shareholder? Since you may have already conducted your due diligence on EML, the undervaluation of the stock may mean it is a good time to top up on your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I've outlined above.
Are you a potential investor? If EML has been on your watch list for a while, it is best you also consider its intrinsic valuation. Looking at PE on its own will not give you the full picture of the stock as an investment, so I suggest you should also look at other relative valuation metrics like EV/EBITDA or PEG.
PE is one aspect of your portfolio construction to consider when holding or entering into a stock. But it is certainly not the only factor. Take a look at our most recent infographic report on Eastern for a more in-depth analysis of the stock to help you make a well-informed investment decision. Since we know a limitation of PE is it doesn't properly account for growth, you can use our free platform to see my list of stocks with a high growth potential and see if their PE is still reasonable.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.