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Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how Insteel Industries, Inc.'s (NASDAQ:IIIN) P/E ratio could help you assess the value on offer. What is Insteel Industries's P/E ratio? Well, based on the last twelve months it is 24.66. In other words, at today's prices, investors are paying $24.66 for every $1 in prior year profit.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Insteel Industries:
P/E of 24.66 = $21.52 ÷ $0.87 (Based on the trailing twelve months to June 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. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.
How Does Insteel Industries's P/E Ratio Compare To Its Peers?
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, Insteel Industries has a higher P/E than the average company (19.4) in the building industry.
That means that the market expects Insteel Industries will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
How Growth Rates Impact P/E Ratios
Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.
Insteel Industries's earnings per share fell by 46% in the last twelve months. But over the longer term (5 years) earnings per share have increased by 2.0%. And it has shrunk its earnings per share by 24% per year over the last three years. This might lead to low expectations.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
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. 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).
So What Does Insteel Industries's Balance Sheet Tell Us?
Since Insteel Industries holds net cash of US$7.4m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Insteel Industries's P/E Ratio
Insteel Industries has a P/E of 24.7. That's higher than the average in its market, which is 18.0. The recent drop in earnings per share might keep value investors away, but the relatively strong balance sheet will allow the company time to invest in growth. Clearly, the high P/E indicates shareholders think it will!
Investors should be looking to buy stocks that the market is wrong about. 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.
But note: Insteel Industries 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).
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.