With a median price-to-earnings (or "P/E") ratio of close to 18x in the United States, you could be forgiven for feeling indifferent about Cummins Inc.'s (NYSE:CMI) P/E ratio of 16.4x. While this might not raise any eyebrows, if the P/E ratio is not justified investors could be missing out on a potential opportunity or ignoring looming disappointment.
Cummins certainly has been doing a good job lately as it's been growing earnings more than most other companies. One possibility is that the P/E is moderate because investors think this strong earnings performance might be about to tail off. If you like the company, you'd be hoping this isn't the case so that you could potentially pick up some stock while it's not quite in favour.
View our latest analysis for Cummins
What Are Growth Metrics Telling Us About The P/E?
Cummins' P/E ratio would be typical for a company that's only expected to deliver moderate growth, and importantly, perform in line with the market.
If we review the last year of earnings growth, the company posted a terrific increase of 48%. The latest three year period has also seen an excellent 49% overall rise in EPS, aided by its short-term performance. Accordingly, shareholders would have probably welcomed those medium-term rates of earnings growth.
Turning to the outlook, the next three years should generate growth of 8.4% per annum as estimated by the analysts watching the company. That's shaping up to be materially lower than the 11% per annum growth forecast for the broader market.
With this information, we find it interesting that Cummins is trading at a fairly similar P/E to the market. It seems most investors are ignoring the fairly limited growth expectations and are willing to pay up for exposure to the stock. These shareholders may be setting themselves up for future disappointment if the P/E falls to levels more in line with the growth outlook.
What We Can Learn From Cummins' P/E?
Typically, we'd caution against reading too much into price-to-earnings ratios when settling on investment decisions, though it can reveal plenty about what other market participants think about the company.
Our examination of Cummins' analyst forecasts revealed that its inferior earnings outlook isn't impacting its P/E as much as we would have predicted. When we see a weak earnings outlook with slower than market growth, we suspect the share price is at risk of declining, sending the moderate P/E lower. This places shareholders' investments at risk and potential investors in danger of paying an unnecessary premium.
You need to take note of risks, for example - Cummins has 2 warning signs (and 1 which is a bit unpleasant) we think you should know about.
Of course, you might also be able to find a better stock than Cummins. So you may wish to see this free collection of other companies that have reasonable P/E ratios and have grown earnings strongly.
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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.