Electromed (NYSEMKT:ELMD) shares have continued recent momentum with a 31% gain in the last month alone. That's tops off a massive gain of 121% in the last year.
All else being equal, a sharp share price increase should make a stock less attractive to potential investors. In the long term, share prices tend to follow earnings per share, but in the short term prices bounce around in response to short term factors (which are not always obvious). The implication here is that deep value investors might steer clear when expectations of a company are too high. One way to gauge market expectations of a stock is to look at its Price to Earnings Ratio (PE Ratio). A high P/E ratio means that investors have a high expectation about future growth, while a low P/E ratio means they have low expectations about future growth.
How Does Electromed's P/E Ratio Compare To Its Peers?
Electromed's P/E of 28.73 indicates relatively low sentiment towards the stock. If you look at the image below, you can see Electromed has a lower P/E than the average (46.6) in the medical equipment industry classification.
Its relatively low P/E ratio indicates that Electromed shareholders think it will struggle to do as well as other companies in its industry classification. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.
In the last year, Electromed grew EPS like Taylor Swift grew her fan base back in 2010; the 92% gain was both fast and well deserved. The cherry on top is that the five year growth rate was an impressive 110% per year. So I'd be surprised if the P/E ratio was not above average.
Remember: P/E Ratios Don't Consider The Balance Sheet
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. 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.
While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
So What Does Electromed's Balance Sheet Tell Us?
The extra options and safety that comes with Electromed's US$9.2m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Verdict On Electromed's P/E Ratio
Electromed trades on a P/E ratio of 28.7, which is above its market average of 18.2. 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). What we know for sure is that investors have become much more excited about Electromed recently, since they have pushed its P/E ratio from 21.9 to 28.7 over the last month. For those who prefer to invest with the flow of momentum, that might mean it's time to put the stock on a watchlist, or research it. But the contrarian may see it as a missed opportunity.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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.
But note: Electromed may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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.
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