Of late the Electro Optic Systems Holdings (ASX:EOS) share price has softened like an ice cream in the sun, melting a full 31%. But plenty of shareholders will still be smiling, given that the stock is up 9.4% over the last quarter. The good news is that in the last year, the stock has shone bright like a diamond, gaining 186%.
Assuming nothing else has changed, a lower share price makes a stock more 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. So, on certain occasions, long term focussed investors try to take advantage of pessimistic expectations to buy shares at a better price. 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). Investors have optimistic expectations of companies with higher P/E ratios, compared to companies with lower P/E ratios.
Does Electro Optic Systems Holdings Have A Relatively High Or Low P/E For Its Industry?
We can tell from its P/E ratio of 37.40 that there is some investor optimism about Electro Optic Systems Holdings. You can see in the image below that the average P/E (21.6) for companies in the aerospace & defense industry is lower than Electro Optic Systems Holdings's P/E.
That means that the market expects Electro Optic Systems Holdings will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. When earnings grow, the 'E' increases, over time. 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.
Most would be impressed by Electro Optic Systems Holdings earnings growth of 12% in the last year.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
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. 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.
While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
Electro Optic Systems Holdings's Balance Sheet
The extra options and safety that comes with Electro Optic Systems Holdings's AU$78m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Bottom Line On Electro Optic Systems Holdings's P/E Ratio
Electro Optic Systems Holdings has a P/E of 37.4. That's higher than the average in its market, which is 17.8. Its strong balance sheet gives the company plenty of resources for extra growth, and it has already proven it can grow. Therefore it seems reasonable that the market would have relatively high expectations of the company Given Electro Optic Systems Holdings's P/E ratio has declined from 53.9 to 37.4 in the last month, we know for sure that the market is significantly less confident about the business today, than it was back then. For those who prefer to invest with the flow of momentum, that might be a bad sign, but for a contrarian, it may signal opportunity.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
But note: Electro Optic Systems Holdings may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio 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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