Interface (NASDAQ:TILE) shareholders are no doubt pleased to see that the share price has bounced 31% in the last month alone, although it is still down 10% over the last quarter. But shareholders may not all be feeling jubilant, since the share price is still down 41% in the last year.
Assuming no other changes, a sharply higher share price makes a stock less attractive to potential buyers. 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. Perhaps the simplest way to get a read on investors' expectations of a business is to look at its Price to Earnings Ratio (PE Ratio). A high P/E implies that investors have high expectations of what a company can achieve compared to a company with a low P/E ratio.
How Does Interface's P/E Ratio Compare To Its Peers?
We can tell from its P/E ratio of 16.01 that sentiment around Interface isn't particularly high. The image below shows that Interface has a lower P/E than the average (25.8) P/E for companies in the commercial services industry.
This suggests that market participants think Interface 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
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. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.
Interface saw earnings per share decrease by 13% last year. But over the longer term (5 years) earnings per share have increased by 3.8%. And it has shrunk its earnings per share by 7.8% per year over the last three years. This could justify a low P/E.
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. 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 Interface's Debt Impact Its P/E Ratio?
Net debt totals 74% of Interface's market cap. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.
The Bottom Line On Interface's P/E Ratio
Interface trades on a P/E ratio of 16.0, which is below the US market average of 17.8. When you consider that the company has significant debt, and didn't grow EPS last year, it isn't surprising that the market has muted expectations. What is very clear is that the market has become more optimistic about Interface over the last month, with the P/E ratio rising from 12.2 back then to 16.0 today. For those who prefer to invest with the flow of momentum, that might mean it's time to put the stock on a watchlist, or research it. But the contrarian may see it as a missed opportunity.
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 visual report on analyst forecasts could hold the key to an excellent investment decision.
You might be able to find a better buy than Interface. 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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