Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at The Eastern Company's (NASDAQ:EML) P/E ratio and reflect on what it tells us about the company's share price. Eastern has a price to earnings ratio of 13.67, based on the last twelve months. In other words, at today's prices, investors are paying $13.67 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 Eastern:
P/E of 13.67 = $27.78 ÷ $2.03 (Based on the trailing twelve months to September 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each $1 the company has earned over the last year. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
How Does Eastern'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. We can see in the image below that the average P/E (22.5) for companies in the machinery industry is higher than Eastern's P/E.
Its relatively low P/E ratio indicates that Eastern shareholders think it will struggle to do as well as other companies in its industry classification. Many investors like to buy stocks when the market is pessimistic about their prospects. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. When earnings grow, the 'E' increases, over time. 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.
Notably, Eastern grew EPS by a whopping 28% in the last year. And earnings per share have improved by 11% annually, over the last five years. With that performance, I would expect it to have an above average P/E ratio.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. So it won't reflect the advantage of cash, or disadvantage of debt. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
So What Does Eastern's Balance Sheet Tell Us?
Eastern has net debt worth 51% of its market capitalization. This is a reasonably significant level of debt -- all else being equal you'd expect a much lower P/E than if it had net cash.
The Bottom Line On Eastern's P/E Ratio
Eastern has a P/E of 13.7. That's below the average in the US market, which is 18.3. The company has a meaningful amount of debt on the balance sheet, but that should not eclipse the solid earnings growth. The low P/E ratio suggests current market expectations are muted, implying these levels of growth will not continue.
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.
But note: Eastern 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).
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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