Mr. Phillips of Southwest Investment Bankers is evaluating the P/E ratio of Madison Electronics Conveyors (MEC). The firm's P/E is currently 17. With earning per share of $2, the stock price is $34.
The average P/E ratio in the electronic conveyor industry is presently 16. However, MEC has an anticipated growth rate of 18 percent versus an industry average of 12 percent, so 2 will be added to the industry P/E by Mr. Phillips. Also, the operating risk associated with MEC is less than that for the industry because of its long-term contract with American Airlines. For this reason, Mr. Phillips will add a factor of 1.5 to the industry P/E ratio.
The debt-to-total-assets ratio is not as encouraging. It is 50 percent, while the industry ratio is 40 percent. In doing his evaluation, Mr. Phillips decides to subtract a factor of 0.5 from the industry P/E ratio. Other ratios, including dividend payout, appear to be in line with the industry, so Mr. Phillips will make no further adjustment along these lines.
However, he is somewhat distressed by the fact that the firm only spent 3 percent of sales on research and development last year, when the industry norm is 7 percent. For this reason he will subtract a factor of 1.5 from the industry P/E ratio.
Despite the relatively low research budget, Mr. Sanders observes that the firm has just hired two of the top executives from a competitor in the industry. He decides to add a factor of 1 to the industry P/E ratio because of this.
a. Determine the P/E ratio for MEC based on Mr. Phillips's analysis.
b. Multiply this times earnings per share, and comment on whether you think the stock might possibly be under- or overvalued in the marketplace at its current P/E and price.