Despite Its High P/E Ratio, Is Transcat, Inc. (NASDAQ:TRNS) Still Undervalued?

This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll look at Transcat, Inc.’s (NASDAQ:TRNS) P/E ratio and reflect on what it tells us about the company’s share price. Transcat has a P/E ratio of 22.65, based on the last twelve months. That is equivalent to an earnings yield of about 4.4%.

See our latest analysis for Transcat

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Transcat:

P/E of 22.65 = $23.34 ÷ $1.03 (Based on the year to June 2019.)

Is A High P/E Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.

How Does Transcat’s P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Transcat has a higher P/E than the average (16.3) P/E for companies in the trade distributors industry.

NasdaqGM:TRNS Price Estimation Relative to Market, September 20th 2019
NasdaqGM:TRNS Price Estimation Relative to Market, September 20th 2019

Its relatively high P/E ratio indicates that Transcat shareholders think it will perform better than other companies in its industry classification.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. 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.

Transcat increased earnings per share by an impressive 14% over the last twelve months. And its annual EPS growth rate over 5 years is 14%. This could arguably justify a relatively high P/E ratio. Shareholders have some reason to be optimistic, but the future is always uncertain. So further research is always essential. I often monitor director buying and selling.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

The ‘Price’ in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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.

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).

So What Does Transcat’s Balance Sheet Tell Us?

Transcat has net debt worth 13% of its market capitalization. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.

The Bottom Line On Transcat’s P/E Ratio

Transcat’s P/E is 22.7 which is above average (18.0) in its market. While the company does use modest debt, its recent earnings growth is very good. Therefore, it’s not particularly surprising that it has a above average P/E ratio.

When the market is wrong about a stock, it gives savvy investors an opportunity. 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 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 Transcat. 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 editorial-team@simplywallst.com. 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.