This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll look at Federal Signal Corporation’s (NYSE:FSS) P/E ratio and reflect on what it tells us about the company’s share price. Federal Signal has a price to earnings ratio of 14.44, based on the last twelve months. That is equivalent to an earnings yield of about 6.9%.
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How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Federal Signal:
P/E of 14.44 = $21.91 ÷ $1.52 (Based on the trailing twelve months to September 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 necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. When earnings grow, the ‘E’ increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
Notably, Federal Signal grew EPS by a whopping 109% in the last year. And earnings per share have improved by 11% annually, over the last three years. So we’d generally expect it to have a relatively high P/E ratio. Unfortunately, earnings per share are down 16% a year, over 5 years.
How Does Federal Signal’s P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. If you look at the image below, you can see Federal Signal has a lower P/E than the average (19.7) in the machinery industry classification.
Federal Signal’s P/E tells us that market participants think it will not fare as well as its peers in the same industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don’t forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining cash).
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 Federal Signal’s Debt Impact Its P/E Ratio?
Federal Signal’s net debt is 14% of its market cap. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.
The Verdict On Federal Signal’s P/E Ratio
Federal Signal trades on a P/E ratio of 14.4, which is below the US market average of 17.1. The company does have a little debt, and EPS growth was good last year. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.
Investors have an opportunity when market expectations about a stock are wrong. 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 visual report on analyst forecasts could hold they key to an excellent investment decision.
Of course you might be able to find a better stock than Federal Signal. So you may wish to see this free collection of other companies that have grown earnings strongly.
To help readers see past 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. For errors that warrant correction please contact the editor at firstname.lastname@example.org.