The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we’ll show how American Vanguard Corporation’s (NYSE:AVD) P/E ratio could help you assess the value on offer. American Vanguard has a P/E ratio of 20.75, based on the last twelve months. That corresponds to an earnings yield of approximately 4.8%.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for American Vanguard:
P/E of 20.75 = $17.85 ÷ $0.86 (Based on the year to September 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. All else being equal, it’s better to pay a low price — but as Warren Buffett said, ‘It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.’
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
American Vanguard increased earnings per share by a whopping 59% last year. And it has improved its earnings per share by 42% per year over the last three years. So we’d generally expect it to have a relatively high P/E ratio. In contrast, EPS has decreased by 1.7%, annually, over 5 years.
How Does American Vanguard’s P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. You can see in the image below that the average P/E (20) for companies in the chemicals industry is roughly the same as American Vanguard’s P/E.
Its P/E ratio suggests that American Vanguard shareholders think that in the future it will perform about the same as other companies in its industry classification. So if American Vanguard actually outperforms its peers going forward, that should be a positive for the share price. Checking factors such as the tenure of the board and management could help you form your own view on if that will happen.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
Don’t forget that the P/E ratio considers market capitalization. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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).
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
Is Debt Impacting American Vanguard’s P/E?
American Vanguard has net debt worth 16% of its market capitalization. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.
The Verdict On American Vanguard’s P/E Ratio
American Vanguard has a P/E of 20.8. That’s higher than the average in the US market, which is 17.9. While the company does use modest debt, its recent earnings growth is impressive. So it is not surprising the market is probably extrapolating recent growth well into the future, reflected in the relatively high P/E ratio.
Investors have an opportunity when market expectations about a stock are wrong. People often underestimate remarkable growth — so investors can make money when fast growth is not fully appreciated. So this free visual report on analyst forecasts could hold they key to an excellent investment decision.
You might be able to find a better buy than American Vanguard. 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).
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.