This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll show how you can use Sterling Construction Company, Inc.’s (NASDAQ:STRL) P/E ratio to inform your assessment of the investment opportunity. Sterling Construction Company has a price to earnings ratio of 13.93, based on the last twelve months. That is equivalent to an earnings yield of about 7.2%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Sterling Construction Company:
P/E of 13.93 = $13.04 ÷ $0.94 (Based on the trailing twelve months to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. That isn’t a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business’s prospects, relative to stocks with a lower P/E.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the ‘E’ will be higher. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.
Notably, Sterling Construction Company grew EPS by a whopping 112% in the last year. And it has bolstered its earnings per share by 68% per year over the last five years. So we’d generally expect it to have a relatively high P/E ratio.
How Does Sterling Construction Company’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. We can see in the image below that the average P/E (18.1) for companies in the construction industry is higher than Sterling Construction Company’s P/E.
Its relatively low P/E ratio indicates that Sterling Construction Company shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Sterling Construction Company, 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.
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).
How Does Sterling Construction Company’s Debt Impact Its P/E Ratio?
Sterling Construction Company has net cash of US$12m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Verdict On Sterling Construction Company’s P/E Ratio
Sterling Construction Company trades on a P/E ratio of 13.9, which is below the US market average of 17.8. It grew its EPS nicely over the last year, and the healthy balance sheet implies there is more potential for growth. One might conclude that the market is a bit pessimistic, given the low P/E ratio. Because analysts are predicting more growth in the future, one might have expected to see a higher P/E ratio. You can taker closer look at the fundamentals, here.
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. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
Of course you might be able to find a better stock than Sterling Construction Company. So you may wish to see this free collection of other companies that have grown earnings strongly.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
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. Thank you for reading.