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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at inTEST Corporation's (NYSEMKT:INTT) P/E ratio and reflect on what it tells us about the company's share price. inTEST has a price to earnings ratio of 23.41, based on the last twelve months. That is equivalent to an earnings yield of about 4.3%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for inTEST:
P/E of 23.41 = $6.87 ÷ $0.29 (Based on the trailing twelve months to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. When earnings grow, the 'E' increases, over time. And in that case, the P/E ratio itself will drop rather quickly. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
In the last year, inTEST grew EPS like Taylor Swift grew her fan base back in 2010; the 210% gain was both fast and well deserved. And earnings per share have improved by 18% annually, over the last three years. So you might say it really deserves to have an above-average P/E ratio.
Does inTEST Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio indicates whether the market has higher or lower expectations of a company. You can see in the image below that the average P/E (20.8) for companies in the semiconductor industry is lower than inTEST's P/E.
inTEST's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn't guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The 'Price' in P/E reflects the market capitalization of the company. So it won't reflect the advantage of cash, or disadvantage of debt. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
So What Does inTEST's Balance Sheet Tell Us?
With net cash of US$18m, inTEST has a very strong balance sheet, which may be important for its business. Having said that, at 25% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On inTEST's P/E Ratio
inTEST trades on a P/E ratio of 23.4, which is above the US market average of 18.3. Its net cash position is the cherry on top of its superb EPS growth. To us, this is the sort of company that we would expect to carry an above average price tag (relative to earnings).
Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
Of course you might be able to find a better stock than inTEST. So you may wish to see this free collection of other companies that have grown earnings strongly.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.