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Unfortunately for some shareholders, the Eaton (NYSE:ETN) share price has dived 34% in the last thirty days. Even longer term holders have taken a real hit with the stock declining 16% in the last year.
All else being equal, a share price drop should make a stock more attractive to potential investors. While the market sentiment towards a stock is very changeable, in the long run, the share price will tend to move in the same direction as earnings per share. The implication here is that long term investors have an opportunity when expectations of a company are too low. One way to gauge market expectations of a stock is to look at its Price to Earnings Ratio (PE Ratio). A high P/E implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.
How Does Eaton's P/E Ratio Compare To Its Peers?
Eaton has a P/E ratio of 13.04. You can see in the image below that the average P/E (13.1) for companies in the electrical industry is roughly the same as Eaton's P/E.
Eaton's P/E tells us that market participants think its prospects are roughly in line with its industry. So if Eaton actually outperforms its peers going forward, that should be a positive for the share price. Further research into factors such as insider buying and selling, could help you form your own view on whether that is likely.
How Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. When earnings grow, the 'E' increases, over time. And in that case, the P/E ratio itself will drop rather quickly. Then, a lower P/E should attract more buyers, pushing the share price up.
Eaton's earnings per share grew by 6.8% in the last twelve months. And its annual EPS growth rate over 5 years is 6.9%.
Remember: P/E Ratios Don't Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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).
Eaton's Balance Sheet
Eaton has net debt equal to 27% of its market cap. You'd want to be aware of this fact, but it doesn't bother us.
The Verdict On Eaton's P/E Ratio
Eaton trades on a P/E ratio of 13.0, which is above its market average of 11.8. With debt at prudent levels and improving earnings, it's fair to say the market expects steady progress in the future. Given Eaton's P/E ratio has declined from 19.8 to 13.0 in the last month, we know for sure that the market is significantly less confident about the business today, than it was back then. For those who don't like to trade against momentum, that could be a warning sign, but a contrarian investor might want to take a closer look.
Investors have an opportunity when market expectations about a stock are wrong. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
You might be able to find a better buy than Eaton. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
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.
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. Thank you for reading.