This article is written for those who want to get better at using price to earnings ratios (P/E ratios). 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. Based on the last twelve months, Insteel Industries’s P/E ratio is 12.26. That corresponds to an earnings yield of approximately 8.2%.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Insteel Industries:
P/E of 12.26 = $20.69 ÷ $1.69 (Based on the trailing twelve months to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. 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 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. Then, a higher P/E might scare off shareholders, pushing the share price down.
Most would be impressed by Insteel Industries earnings growth of 23% in the last year. And earnings per share have improved by 16% annually, over the last five years. With that performance, you might expect an above average P/E ratio. Unfortunately, earnings per share are down 1.7% a year, over 3 years.
How Does Insteel Industries’s P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. If you look at the image below, you can see Insteel Industries has a lower P/E than the average (16) in the building industry classification.
Its relatively low P/E ratio indicates that Insteel Industries 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. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don’t forget that the P/E ratio considers market capitalization. That means it doesn’t take debt or cash into account. 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.
How Does Insteel Industries’s Debt Impact Its P/E Ratio?
Since Insteel Industries holds net cash of US$16m, 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 trades on a P/E ratio of 12.3, which is below the US market average of 16.8. 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.
When the market is wrong about a stock, it gives savvy investors an opportunity. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
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.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.