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This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to MTS Systems Corporation's (NASDAQ:MTSC), to help you decide if the stock is worth further research. What is MTS Systems's P/E ratio? Well, based on the last twelve months it is 23.94. In other words, at today's prices, investors are paying $23.94 for every $1 in prior year profit.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for MTS Systems:
P/E of 23.94 = $55.32 ÷ $2.31 (Based on the year to March 2019.)
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. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.'
How Growth Rates Impact P/E Ratios
If earnings fall then in the future the 'E' will be lower. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
MTS Systems saw earnings per share decrease by 24% last year. And EPS is down 6.5% a year, over the last 5 years. This could justify a pessimistic P/E.
Does MTS Systems Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. As you can see below, MTS Systems has a higher P/E than the average company (18.7) in the electronic industry.
Its relatively high P/E ratio indicates that MTS Systems shareholders think it will perform better than other companies in its industry classification. Clearly the market expects growth, but it isn't guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won't reflect the advantage of cash, or disadvantage of debt. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
How Does MTS Systems's Debt Impact Its P/E Ratio?
MTS Systems's net debt equates to 39% of its market capitalization. You'd want to be aware of this fact, but it doesn't bother us.
The Verdict On MTS Systems's P/E Ratio
MTS Systems's P/E is 23.9 which is above average (17.3) in the US market. With a bit of debt, but a lack of recent growth, it's safe to say the market is expecting improved profit performance from the company, in the next few years.
Investors should be looking to buy stocks that the market is wrong about. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course you might be able to find a better stock than MTS Systems. 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 firstname.lastname@example.org. 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.