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Luna Innovations (NASDAQ:LUNA) shareholders are no doubt pleased to see that the share price has bounced 30% in the last month alone, although it is still down 6.8% over the last quarter. That brought the twelve month gain to a very sharp 67%.
Assuming no other changes, a sharply higher share price makes a stock less attractive to potential buyers. In the long term, share prices tend to follow earnings per share, but in the short term prices bounce around in response to short term factors (which are not always obvious). 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). A high P/E ratio means that investors have a high expectation about future growth, while a low P/E ratio means they have low expectations about future growth.
How Does Luna Innovations's P/E Ratio Compare To Its Peers?
Luna Innovations's P/E of 43.29 indicates some degree of optimism towards the stock. As you can see below, Luna Innovations has a higher P/E than the average company (17.8) in the electronic industry.
That means that the market expects Luna Innovations will outperform other companies in its industry. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.
In the last year, Luna Innovations grew EPS like Taylor Swift grew her fan base back in 2010; the 396% gain was both fast and well deserved.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
Don't forget that the P/E ratio considers market capitalization. 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.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
Luna Innovations's Balance Sheet
With net cash of US$25m, Luna Innovations has a very strong balance sheet, which may be important for its business. Having said that, at 11% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On Luna Innovations's P/E Ratio
Luna Innovations's P/E is 43.3 which is above average (14.9) in its market. The excess cash it carries is the gravy on top its fast EPS growth. So based on this analysis we'd expect Luna Innovations to have a high P/E ratio. What is very clear is that the market has become significantly more optimistic about Luna Innovations over the last month, with the P/E ratio rising from 33.2 back then to 43.3 today. If you like to buy stocks that have recently impressed the market, then this one might be a candidate; but if you prefer to invest when there is 'blood in the streets', then you may feel the opportunity has passed.
Investors should be looking to buy stocks that the market is wrong about. 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 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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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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