Educational Development (NASDAQ:EDUC) shareholders are no doubt pleased to see that the share price has had a great month, posting a 33% gain, recovering from prior weakness. But shareholders may not all be feeling jubilant, since the share price is still down 20% in the last year.
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. So some would prefer to hold off buying when there is a lot of optimism towards a stock. 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 Educational Development Have A Relatively High Or Low P/E For Its Industry?
Educational Development's P/E of 9.50 indicates relatively low sentiment towards the stock. We can see in the image below that the average P/E (20.0) for companies in the retail distributors industry is higher than Educational Development's P/E.
This suggests that market participants think Educational Development will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. Earnings growth means that in the future the 'E' will be higher. And in that case, the P/E ratio itself will drop rather quickly. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Educational Development shrunk earnings per share by 17% over the last year. But EPS is up 45% over the last 5 years.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
The 'Price' in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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.
Is Debt Impacting Educational Development's P/E?
Net debt totals 18% of Educational Development'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 Educational Development's P/E Ratio
Educational Development has a P/E of 9.5. That's below the average in the US market, which is 15.0. 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 we know for sure is that investors are becoming less uncomfortable about Educational Development's prospects, since they have pushed its P/E ratio from 7.1 to 9.5 over the last month. For those who like to invest in turnarounds, that might mean it's time to put the stock on a watchlist, or research it. But others might consider the opportunity to have passed.
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. We don't have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than Educational Development. 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).
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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned. Thank you for reading.