This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll look at Culp, Inc.’s (NYSE:CULP) P/E ratio and reflect on what it tells us about the company’s share price. Culp has a price to earnings ratio of 14.87, based on the last twelve months. That means that at current prices, buyers pay $14.87 for every $1 in trailing yearly profits.
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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 Culp:
P/E of 14.87 = $18.84 ÷ $1.27 (Based on the year to October 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each $1 the company has earned over the last year. All else being equal, it’s better to pay a low price — but as Warren Buffett said, ‘It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.’
How Growth Rates Impact P/E Ratios
Companies that shrink earnings per share quickly will rapidly decrease the ‘E’ in the equation. That means unless the share price falls, the P/E will increase in a few years. A higher P/E should indicate the stock is expensive relative to others — and that may encourage shareholders to sell.
Culp shrunk earnings per share by 27% over the last year. But EPS is up 3.4% over the last 5 years.
How Does Culp’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 (17.8) for companies in the luxury industry is higher than Culp’s P/E.
Culp’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. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
How Does Culp’s Debt Impact Its P/E Ratio?
Since Culp holds net cash of US$41m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Culp’s P/E Ratio
Culp has a P/E of 14.9. That’s below the average in the US market, which is 17.1. Falling earnings per share are likely to be keeping potential buyers away, the healthy balance sheet means the company retains potential for future growth. If that occurs, the current low P/E could prove to be temporary.
Investors should be looking to buy stocks that the market is wrong about. 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 find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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 editorial-team@simplywallst.com.