Despite an already strong run, The Eastern Company (NASDAQ:EML) shares have been powering on, with a gain of 29% in the last thirty days. Looking back a bit further, it's encouraging to see the stock is up 63% in the last year.
Following the firm bounce in price, Eastern's price-to-earnings (or "P/E") ratio of 22.5x might make it look like a sell right now compared to the market in the United States, where around half of the companies have P/E ratios below 16x and even P/E's below 9x are quite common. However, the P/E might be high for a reason and it requires further investigation to determine if it's justified.
For example, consider that Eastern's financial performance has been poor lately as its earnings have been in decline. One possibility is that the P/E is high because investors think the company will still do enough to outperform the broader market in the near future. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.
Does Growth Match The High P/E?
In order to justify its P/E ratio, Eastern would need to produce impressive growth in excess of the market.
Taking a look back first, the company's earnings per share growth last year wasn't something to get excited about as it posted a disappointing decline of 23%. The last three years don't look nice either as the company has shrunk EPS by 22% in aggregate. Therefore, it's fair to say the earnings growth recently has been undesirable for the company.
Comparing that to the market, which is predicted to deliver 11% growth in the next 12 months, the company's downward momentum based on recent medium-term earnings results is a sobering picture.
With this information, we find it concerning that Eastern is trading at a P/E higher than the market. It seems most investors are ignoring the recent poor growth rate and are hoping for a turnaround in the company's business prospects. There's a very good chance existing shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the recent negative growth rates.
The Bottom Line On Eastern's P/E
The large bounce in Eastern's shares has lifted the company's P/E to a fairly high level. We'd say the price-to-earnings ratio's power isn't primarily as a valuation instrument but rather to gauge current investor sentiment and future expectations.
We've established that Eastern currently trades on a much higher than expected P/E since its recent earnings have been in decline over the medium-term. Right now we are increasingly uncomfortable with the high P/E as this earnings performance is highly unlikely to support such positive sentiment for long. Unless the recent medium-term conditions improve markedly, it's very challenging to accept these prices as being reasonable.
You always need to take note of risks, for example - Eastern has 1 warning sign we think you should be aware of.
You might be able to find a better investment than Eastern. If you want a selection of possible candidates, check out this free list of interesting companies that trade on a low P/E (but have proven they can grow earnings).
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.