To the annoyance of some shareholders, Proto Labs (NYSE:PRLB) shares are down a considerable 34% in the last month. That drop has capped off a tough year for shareholders, with the share price down 38% in that time.
All else being equal, a share price drop should make a stock more 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 long term investors have an opportunity when expectations of a company are too low. One way to gauge market expectations of a stock is to look at its Price to Earnings Ratio (PE Ratio). Investors have optimistic expectations of companies with higher P/E ratios, compared to companies with lower P/E ratios.
Does Proto Labs Have A Relatively High Or Low P/E For Its Industry?
Proto Labs's P/E of 27.91 indicates some degree of optimism towards the stock. As you can see below, Proto Labs has a higher P/E than the average company (14.6) in the machinery industry.
That means that the market expects Proto Labs 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
Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the 'E' will be higher. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Proto Labs saw earnings per share decrease by 17% last year. But EPS is up 7.9% over the last 5 years.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. 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.
How Does Proto Labs's Debt Impact Its P/E Ratio?
Since Proto Labs holds net cash of US$161m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Proto Labs's P/E Ratio
Proto Labs trades on a P/E ratio of 27.9, which is above its market average of 12.7. The recent drop in earnings per share might keep value investors away, but the healthy balance sheet means the company retains the potential for future growth. If this growth fails to materialise, the current high P/E could prove to be temporary, as the share price falls. Given Proto Labs's P/E ratio has declined from 42.3 to 27.9 in the last month, we know for sure that the market is significantly less confident about the business today, than it was back then. For those who don't like to trade against momentum, that could be a warning sign, but a contrarian investor might want to take a closer look.
Investors have an opportunity when market expectations about a stock are wrong. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. 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.
You might be able to find a better buy than Proto Labs. 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 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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