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Here's How P/E Ratios Can Help Us Understand Culp, Inc. (NYSE:CULP)

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This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll look at Culp, Inc.'s (NYSE:CULP) P/E ratio and reflect on what it tells us about the company's share price. Based on the last twelve months, Culp's P/E ratio is 11.97. That corresponds to an earnings yield of approximately 8.4%.

Check out our latest analysis for Culp

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Culp:

P/E of 11.97 = $18.9 ÷ $1.58 (Based on the year to January 2019.)

Is A High P/E Ratio Good?

A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. 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

Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means even if the current P/E is low, it will increase over time if the share price stays flat. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.

Culp increased earnings per share by a whopping 35% last year. And earnings per share have improved by 2.4% annually, over the last five years. So we'd generally expect it to have a relatively high P/E ratio.

How Does Culp's P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. The image below shows that Culp has a lower P/E than the average (16.5) P/E for companies in the luxury industry.

NYSE:CULP Price Estimation Relative to Market, April 3rd 2019

This suggests that market participants think Culp will underperform other companies in its industry. Since the market seems unimpressed with Culp, it's quite possible it could surprise on the upside. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

Remember: P/E Ratios Don't Consider The Balance Sheet

The 'Price' in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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).

Is Debt Impacting Culp's P/E?

The extra options and safety that comes with Culp's US$40m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.

The Bottom Line On Culp's P/E Ratio

Culp's P/E is 12 which is below average (17.7) in the US market. The net cash position gives plenty of options to the business, and the recent improvement in EPS is good to see. One might conclude that the market is a bit pessimistic, given the low P/E ratio.

Investors should be looking to buy stocks that the market is wrong about. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

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 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. Thank you for reading.