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Read This Before You Buy Servotronics, Inc. (NYSEMKT:SVT) Because Of Its P/E Ratio

Simply Wall St

Servotronics (NYSEMKT:SVT) shares have retraced a considerable in the last month. The recent drop has obliterated the annual return, with the share price now down 4.7% over that longer period. But shareholders who bought at the right time will be smiling, given that the stock is up 7.7% over the last quarter.

All else being equal, a sharp share price increase should make a stock less attractive to potential investors. 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). Investors have optimistic expectations of companies with higher P/E ratios, compared to companies with lower P/E ratios.

Check out our latest analysis for Servotronics

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

We can tell from its P/E ratio of 8.39 that sentiment around Servotronics isn't particularly high. The image below shows that Servotronics has a lower P/E than the average (19.0) P/E for companies in the electrical industry.

AMEX:SVT Price Estimation Relative to Market, January 5th 2020

Servotronics's P/E tells us that market participants think it will not fare as well as its peers in the same industry. 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.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. When earnings grow, the 'E' increases, over time. And in that case, the P/E ratio itself will drop rather quickly. Then, a lower P/E should attract more buyers, pushing the share price up.

Servotronics's earnings per share fell by 4.6% in the last twelve months. But EPS is up 10% over the last 3 years.

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

Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. 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.

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.

Servotronics's Balance Sheet

Servotronics's net debt is 9.7% of its market cap. It would probably trade on a higher P/E ratio if it had a lot of cash, but I doubt it is having a big impact.

The Verdict On Servotronics's P/E Ratio

Servotronics trades on a P/E ratio of 8.4, which is below the US market average of 18.8. Since it only carries a modest debt load, it's likely the low expectations implied by the P/E ratio arise from the lack of recent earnings growth. What can be absolutely certain is that the market has become more pessimistic about Servotronics over the last month, with the P/E ratio falling from 8.4 back then to 8.4 today. For those who prefer invest in growth, this stock apparently offers limited promise, but the deep value investors may find the pessimism around this stock enticing.

Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. We don't have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.

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

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.

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. Thank you for reading.