With a price-to-earnings (or "P/E") ratio of 23.3x Illinois Tool Works Inc. (NYSE:ITW) may be sending bearish signals at the moment, given that almost half of all companies in the United States have P/E ratios under 17x and even P/E's lower than 10x are not unusual. Nonetheless, we'd need to dig a little deeper to determine if there is a rational basis for the elevated P/E.
With its earnings growth in positive territory compared to the declining earnings of most other companies, Illinois Tool Works has been doing quite well of late. The P/E is probably high because investors think the company will continue to navigate the broader market headwinds better than most. You'd really hope so, otherwise you're paying a pretty hefty price for no particular reason.
Does Growth Match The High P/E?
Illinois Tool Works' P/E ratio would be typical for a company that's expected to deliver solid growth, and importantly, perform better than the market.
Retrospectively, the last year delivered virtually the same number to the company's bottom line as the year before. Regardless, EPS has managed to lift by a handy 22% in aggregate from three years ago, thanks to the earlier period of growth. Accordingly, shareholders probably wouldn't have been overly satisfied with the unstable medium-term growth rates.
Shifting to the future, estimates from the analysts covering the company suggest earnings should grow by 6.3% each year over the next three years. With the market predicted to deliver 10% growth per year, the company is positioned for a weaker earnings result.
In light of this, it's alarming that Illinois Tool Works' P/E sits above the majority of other companies. It seems most investors are hoping for a turnaround in the company's business prospects, but the analyst cohort is not so confident this will happen. There's a good chance these shareholders are setting themselves up for future disappointment if the P/E falls to levels more in line with the growth outlook.
The Final Word
It's argued the price-to-earnings ratio is an inferior measure of value within certain industries, but it can be a powerful business sentiment indicator.
Our examination of Illinois Tool Works' analyst forecasts revealed that its inferior earnings outlook isn't impacting its high P/E anywhere near 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 high P/E lower. Unless these conditions improve markedly, it's very challenging to accept these prices as being reasonable.
There are also other vital risk factors to consider before investing and we've discovered 1 warning sign for Illinois Tool Works that you should be aware of.
If P/E ratios interest you, you may wish to see this free collection of other companies with strong earnings growth and low P/E ratios.
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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.