inTEST Corporation (AMEX:INTT) trades with a trailing P/E of 14.6x, which is lower than the industry average of 36x. While this makes INTT 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. Check out our latest analysis for inTEST
What you need to know about the P/E ratio
The P/E ratio is one of many ratios used in 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.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for INTT
Price per share = 7.95
Earnings per share = 0.546
∴ Price-Earnings Ratio = 7.95 ÷ 0.546 = 14.6x
The P/E ratio itself doesn’t tell you a lot; however, it becomes very insightful when you compare it with other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as INTT, such as size and country of operation. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
INTT’s P/E of 14.6x is lower than its industry peers (36x), which implies that each dollar of INTT’s earnings is being undervalued by investors. Therefore, according to this analysis, INTT is an under-priced stock.
Assumptions to watch out for
Before you jump to the conclusion that INTT represents the perfect buying opportunity, it is important to realise that our conclusion rests on two important assertions. The first is that our “similar companies” are actually similar to INTT. If the companies aren’t similar, the difference in P/E might be a result of other factors. For example, if you inadvertently compared lower risk firms with INTT, then investors would naturally value INTT at a lower price since it is a riskier investment. Similarly, if you accidentally compared higher growth firms with INTT, investors would also value INTT at a lower price since it is a lower growth investment. Both scenarios would explain why INTT has a lower P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing INTT to are fairly valued by the market. If this assumption does not hold true, INTT’s lower P/E ratio may be because firms in our peer group are being overvalued by the market.
What this means for you:
Are you a shareholder? If your personal research into the stock confirms what the P/E ratio is telling you, it might be a good time to add more of INTT to your portfolio. But keep in mind that the usefulness of relative valuation depends on whether you are comfortable with making the assumptions I mentioned above.
Are you a potential investor? If INTT 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 inTEST 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.