With a price-to-earnings (or "P/E") ratio of 22.2x 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 18x and even P/E's lower than 11x are not unusual. However, the P/E might be high for a reason and it requires further investigation to determine if it's justified.
Illinois Tool Works certainly has been doing a good job lately as it's been growing earnings more than most other companies. It seems that many are expecting the strong earnings performance to persist, which has raised the P/E. If not, then existing shareholders might be a little nervous about the viability of the share price.
How Is Illinois Tool Works' Growth Trending?
There's an inherent assumption that a company should outperform the market for P/E ratios like Illinois Tool Works' to be considered reasonable.
If we review the last year of earnings growth, the company posted a worthy increase of 12%. The latest three year period has also seen an excellent 36% overall rise in EPS, aided somewhat by its short-term performance. So we can start by confirming that the company has done a great job of growing earnings over that time.
Shifting to the future, estimates from the analysts covering the company suggest earnings should grow by 2.2% each year over the next three years. That's shaping up to be materially lower than the 11% per annum growth forecast for the broader market.
In light of this, it's alarming that Illinois Tool Works' P/E sits above the majority of other companies. Apparently many investors in the company are way more bullish than analysts indicate and aren't willing to let go of their stock at any price. 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 Key Takeaway
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.
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. Right now we are increasingly uncomfortable with the high P/E as the predicted future earnings aren't likely to support such positive sentiment for long. This places shareholders' investments at significant risk and potential investors in danger of paying an excessive premium.
Plus, you should also learn about this 1 warning sign we've spotted with Illinois Tool Works.
If you're unsure about the strength of Illinois Tool Works' business, why not explore our interactive list of stocks with solid business fundamentals for some other companies you may have missed.
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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.
