This article is intended for those of you who are at the beginning of your investing journey and want to learn about the link between company’s fundamentals and stock market performance.
Insteel Industries Inc (NASDAQ:IIIN) is currently trading at a trailing P/E of 25.2x, which is higher than the industry average of 21.1x. While this makes IIIN appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. In this article, I will break down what the P/E ratio is, how to interpret it and what to watch out for.
What you need to know about the P/E ratio
A common ratio used for relative valuation is the P/E ratio. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for IIIN
Price-Earnings Ratio = Price per share ÷ Earnings per share
IIIN Price-Earnings Ratio = $40.58 ÷ $1.609 = 25.2x
The P/E ratio isn’t a metric you view in isolation and only becomes useful when you compare it against other similar companies. We want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as IIIN, such as size and country of operation. A quick method of creating a peer group is to use companies in the same industry, which is what I will do. IIIN’s P/E of 25.2x is higher than its industry peers (21.1x), which implies that each dollar of IIIN’s earnings is being overvalued by investors. This multiple is a median of profitable companies of 25 Building companies in US including Noda, Compagnie de Saint-Gobain and Compagnie de Saint-Gobain. As such, our analysis shows that IIIN represents an over-priced stock.
A few caveats
However, before you rush out to sell your IIIN shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to IIIN. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with IIIN, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing IIIN to are fairly valued by the market. If this does not hold true, IIIN’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
What this means for you:
Since you may have already conducted your due diligence on IIIN, the overvaluation of the stock may mean it is a good time to reduce 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. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I urge you to complete your research by taking a look at the following:
- Future Outlook: What are well-informed industry analysts predicting for IIIN’s future growth? Take a look at our free research report of analyst consensus for IIIN’s outlook.
- Past Track Record: Has IIIN been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of IIIN’s historicals for more clarity.
- Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.
To help readers see past 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. For errors that warrant correction please contact the editor at email@example.com.