The LGL Group (NYSEMKT:LGL) share price has done well in the last month, posting a gain of 37%. Zooming out, the annual gain of 106% knocks our socks off.
Assuming no other changes, a sharply higher share price makes a stock less attractive to potential buyers. 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 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.
Does LGL Group Have A Relatively High Or Low P/E For Its Industry?
We can tell from its P/E ratio of 10.62 that sentiment around LGL Group isn't particularly high. We can see in the image below that the average P/E (20.3) for companies in the electronic industry is higher than LGL Group's P/E.
LGL Group's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Since the market seems unimpressed with LGL Group, 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.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.
LGL Group's 421% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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.
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.
Is Debt Impacting LGL Group's P/E?
With net cash of US$20m, LGL Group has a very strong balance sheet, which may be important for its business. Having said that, at 30% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On LGL Group's P/E Ratio
LGL Group has a P/E of 10.6. That's below the average in the US market, which is 18.1. Not only should the net cash position reduce risk, but the recent growth has been impressive. The below average P/E ratio suggests that market participants don't believe the strong growth will continue. What is very clear is that the market has become more optimistic about LGL Group over the last month, with the P/E ratio rising from 7.7 back then to 10.6 today. If you like to buy stocks that have recently impressed the market, then this one might be a candidate; but if you prefer to invest when there is 'blood in the streets', then you may feel the opportunity has passed.
When the market is wrong about a stock, it gives savvy investors an opportunity. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine. Although we don't have analyst forecasts you could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.
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.
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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