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Here's How P/E Ratios Can Help Us Understand Espey Mfg. & Electronics Corp. (NYSEMKT:ESP)

Simply Wall St

To the annoyance of some shareholders, Espey Mfg. & Electronics (NYSEMKT:ESP) shares are down a considerable in the last month. Even longer term holders have taken a real hit with the stock declining 22% 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 implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.

See our latest analysis for Espey Mfg. & Electronics

Does Espey Mfg. & Electronics Have A Relatively High Or Low P/E For Its Industry?

Espey Mfg. & Electronics's P/E of 20.72 indicates some degree of optimism towards the stock. You can see in the image below that the average P/E (18.7) for companies in the electrical industry is lower than Espey Mfg. & Electronics's P/E.

AMEX:ESP Price Estimation Relative to Market, December 15th 2019
AMEX:ESP Price Estimation Relative to Market, December 15th 2019

That means that the market expects Espey Mfg. & Electronics will outperform other companies in its industry. 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.

How Growth Rates Impact P/E Ratios

If earnings fall then in the future the 'E' will be lower. That means even if the current P/E is low, it will increase over time if the share price stays flat. Then, a higher P/E might scare off shareholders, pushing the share price down.

Espey Mfg. & Electronics shrunk earnings per share by 14% over the last year. But it has grown its earnings per share by 17% per year over the last five years. And EPS is down 5.8% a year, over the last 3 years. This might lead to low expectations.

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. That means it doesn't take debt or cash into account. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.

Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

How Does Espey Mfg. & Electronics's Debt Impact Its P/E Ratio?

With net cash of US$10m, Espey Mfg. & Electronics has a very strong balance sheet, which may be important for its business. Having said that, at 21% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Bottom Line On Espey Mfg. & Electronics's P/E Ratio

Espey Mfg. & Electronics has a P/E of 20.7. That's higher than the average in its market, which is 18.6. Falling earnings per share is probably keeping traditional value investors away, but the net cash position means the company has time to improve: and the high P/E suggests the market thinks it will. What can be absolutely certain is that the market has become less optimistic about Espey Mfg. & Electronics over the last month, with the P/E ratio falling from 20.7 back then to 20.7 today. For those who prefer to invest with the flow of momentum, that might be a bad sign, but for a contrarian, it may signal opportunity.

When the market is wrong about a stock, it gives savvy investors an opportunity. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. We don't have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.

You might be able to find a better buy than Espey Mfg. & Electronics. 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 editorial-team@simplywallst.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.

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.