To the annoyance of some shareholders, L.S. Starrett (NYSE:SCX) shares are down a considerable 33% in the last month. Indeed the recent decline has arguably caused some bitterness for shareholders who have held through the 53% drop over twelve months.
All else being equal, a share price drop should make a stock more attractive to potential investors. 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). The implication here is that long term investors have an opportunity when expectations of a company are too low. 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 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 L.S. Starrett’s P/E Ratio Compare To Its Peers?
L.S. Starrett’s P/E of 4.36 indicates relatively low sentiment towards the stock. The image below shows that L.S. Starrett has a lower P/E than the average (16.9) P/E for companies in the machinery industry.
Its relatively low P/E ratio indicates that L.S. Starrett shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with L.S. Starrett, it’s quite possible it could surprise on the upside. 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
Generally speaking the rate of earnings growth has a profound impact on a company’s P/E multiple. 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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
It’s great to see that L.S. Starrett grew EPS by 15% in the last year. Unfortunately, earnings per share are down 6.9% a year, over 5 years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn’t take debt or cash into account. 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).
L.S. Starrett’s Balance Sheet
Net debt totals 51% of L.S. Starrett’s market cap. This is a reasonably significant level of debt — all else being equal you’d expect a much lower P/E than if it had net cash.
The Bottom Line On L.S. Starrett’s P/E Ratio
L.S. Starrett trades on a P/E ratio of 4.4, which is below the US market average of 14.0. The company has a meaningful amount of debt on the balance sheet, but that should not eclipse the solid earnings growth. If the company can continue to grow earnings, then the current P/E may be unjustifiably low. What can be absolutely certain is that the market has become more pessimistic about L.S. Starrett over the last month, with the P/E ratio falling from 6.5 back then to 4.4 today. For those who prefer to invest with the flow of momentum, that might be a bad sign, but for deep value investors this stock might justify some research.
When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. We don’t have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.
You might be able to find a better buy than L.S. Starrett. 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).
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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