The Eastern Company (NASDAQ:EML) trades with a trailing P/E of 35.2x, which is higher than the industry average of 23.8x. While this makes EML appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will deconstruct the P/E ratio and highlight what you need to be careful of when using the P/E ratio. View our latest analysis for Eastern
What you need to know about the P/E ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. By comparing a stock’s price per share to its earnings per share, we are able to see how much investors are paying for each dollar of the company’s earnings.
P/E Calculation for EML
Price-Earnings Ratio = Price per share ÷ Earnings per share
EML Price-Earnings Ratio = $28.4 ÷ $0.806 = 35.2x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. We preferably want to compare the stock’s P/E ratio to the average of companies that have similar features to EML, such as capital structure and profitability. One way of gathering a peer group is to use firms in the same industry, which is what I’ll do. At 35.2x, EML’s P/E is higher than its industry peers (23.8x). This implies that investors are overvaluing each dollar of EML’s earnings. Therefore, according to this analysis, EML is an over-priced stock.
Assumptions to watch out for
However, before you rush out to sell your EML shares, it is important to note that this conclusion is based on two key assumptions. Firstly, our peer group contains companies that are similar to EML. If this isn’t the case, the difference in P/E could be due to other factors. For example, if you are comparing lower risk firms with EML, then its P/E would naturally be lower than its peers, as investors would value those with lower risk at a higher price. The second assumption that must hold true is that the stocks we are comparing EML to are fairly valued by the market. If this does not hold true, EML’s lower P/E ratio may be because firms in our peer group are overvalued by the market.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.