This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Advanced Drainage Systems, Inc.’s (NYSE:WMS) P/E ratio could help you assess the value on offer. Advanced Drainage Systems has a P/E ratio of 22.78, based on the last twelve months. In other words, at today’s prices, investors are paying $22.78 for every $1 in prior year profit.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Advanced Drainage Systems:
P/E of 22.78 = $25.74 ÷ $1.13 (Based on the trailing twelve months to December 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
How Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. When earnings grow, the ‘E’ increases, over time. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.
Advanced Drainage Systems increased earnings per share by a whopping 43% last year. And earnings per share have improved by 63% annually, over the last five years. So we’d generally expect it to have a relatively high P/E ratio.
How Does Advanced Drainage Systems’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Advanced Drainage Systems has a higher P/E than the average (18.7) P/E for companies in the building industry.
Its relatively high P/E ratio indicates that Advanced Drainage Systems shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn’t guarantee future growth. So further research is always essential. I often monitor director buying and selling.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
The ‘Price’ in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
Advanced Drainage Systems’s Balance Sheet
Advanced Drainage Systems has net debt worth 20% of its market capitalization. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.
The Verdict On Advanced Drainage Systems’s P/E Ratio
Advanced Drainage Systems has a P/E of 22.8. That’s higher than the average in the US market, which is 17.6. The company is not overly constrained by its modest debt levels, and it is growing earnings per share. Therefore it seems reasonable that the market would have relatively high expectations of the company
Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
Of course you might be able to find a better stock than Advanced Drainage Systems. So you may wish to see this free collection of other companies that have grown earnings strongly.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.