This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We’ll show how you can use American Eagle Outfitters, Inc.’s (NYSE:AEO) P/E ratio to inform your assessment of the investment opportunity. American Eagle Outfitters has a price to earnings ratio of 12.91, based on the last twelve months. That means that at current prices, buyers pay $12.91 for every $1 in trailing yearly profits.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for American Eagle Outfitters:
P/E of 12.91 = $20.4 ÷ $1.58 (Based on the trailing twelve months to November 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn’t necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. When earnings grow, the ‘E’ increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
It’s nice to see that American Eagle Outfitters grew EPS by a stonking 69% in the last year. And it has bolstered its earnings per share by 24% per year over the last five years. With that performance, I would expect it to have an above average P/E ratio.
How Does American Eagle Outfitters’s P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that American Eagle Outfitters has a lower P/E than the average (16.4) P/E for companies in the specialty retail industry.
This suggests that market participants think American Eagle Outfitters will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn’t take debt or cash into account. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining cash).
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
American Eagle Outfitters’s Balance Sheet
The extra options and safety that comes with American Eagle Outfitters’s US$360m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Bottom Line On American Eagle Outfitters’s P/E Ratio
American Eagle Outfitters trades on a P/E ratio of 12.9, which is below the US market average of 17.6. The net cash position gives plenty of options to the business, and the recent improvement in EPS is good to see. The relatively low P/E ratio implies the market is pessimistic.
Investors have an opportunity when market expectations about a stock are wrong. As value investor Benjamin Graham famously said, ‘In the short run, the market is a voting machine but in the long run, it is a weighing machine.’ 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.
You might be able to find a better buy than American Eagle Outfitters. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
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If you spot an error that warrants correction, please contact the editor at email@example.com. 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.