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Read This Before You Buy Methode Electronics, Inc. (NYSE:MEI) Because Of Its P/E Ratio

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This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll show how you can use Methode Electronics, Inc.'s (NYSE:MEI) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Methode Electronics's P/E ratio is 9.53. That is equivalent to an earnings yield of about 10%.

See our latest analysis for Methode Electronics

How Do I Calculate A Price To Earnings Ratio?

The formula for P/E is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Methode Electronics:

P/E of 9.53 = $26.99 ÷ $2.83 (Based on the trailing twelve months to January 2019.)

Is A High P/E 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 Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. Earnings growth means that in the future the 'E' will be higher. That means unless the share price increases, the P/E will reduce in a few years. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

Methode Electronics's earnings made like a rocket, taking off 139% last year. Having said that, if we look back three years, EPS growth has averaged a comparatively less impressive 7.3%.

Does Methode Electronics Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio essentially measures market expectations of a company. We can see in the image below that the average P/E (18.3) for companies in the electronic industry is higher than Methode Electronics's P/E.

NYSE:MEI Price Estimation Relative to Market, June 21st 2019

Methode Electronics'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 Methode Electronics, it's quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).

Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.

How Does Methode Electronics's Debt Impact Its P/E Ratio?

Net debt totals 23% of Methode Electronics's market cap. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.

The Verdict On Methode Electronics's P/E Ratio

Methode Electronics trades on a P/E ratio of 9.5, which is below the US market average of 18. The EPS growth last year was strong, and debt levels are quite reasonable. If the company can continue to grow earnings, then the current P/E may be unjustifiably low. Given analysts are expecting further growth, one might have expected a higher P/E ratio. That may be worth further research.

Investors have an opportunity when market expectations about a stock are wrong. 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.' So this free report on the analyst consensus forecasts could help you make a master move on this stock.

Of course you might be able to find a better stock than Methode Electronics. So you may wish to see this free collection of other companies that have grown earnings strongly.

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 editorial-team@simplywallst.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. Thank you for reading.