The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at Canadian Pacific Railway Limited's (TSE:CP) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, Canadian Pacific Railway has a P/E ratio of 18.90. That is equivalent to an earnings yield of about 5.3%.
How Do I Calculate Canadian Pacific Railway's Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Canadian Pacific Railway:
P/E of 18.90 = CA$313.39 ÷ CA$16.58 (Based on the trailing twelve months to September 2019.)
Is A High Price-to-Earnings Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.
How Does Canadian Pacific Railway's P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. As you can see below Canadian Pacific Railway has a P/E ratio that is fairly close for the average for the transportation industry, which is 18.8.
Its P/E ratio suggests that Canadian Pacific Railway shareholders think that in the future it will perform about the same as other companies in its industry classification. So if Canadian Pacific Railway actually outperforms its peers going forward, that should be a positive for the share price. Further research into factors such as insider buying and selling, could help you form your own view on whether that is likely.
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. Earnings growth means that in the future the 'E' will be higher. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Canadian Pacific Railway maintained roughly steady earnings over the last twelve months. But it has grown its earnings per share by 21% per year over the last five years.
Remember: P/E Ratios Don't Consider The Balance Sheet
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. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
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.
Is Debt Impacting Canadian Pacific Railway's P/E?
Canadian Pacific Railway 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 Canadian Pacific Railway's P/E Ratio
Canadian Pacific Railway's P/E is 18.9 which is above average (14.8) in its market. With a bit of debt, but a lack of recent growth, it's safe to say the market is expecting improved profit performance from the company, in the next few years.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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 the key to an excellent investment decision.
But note: Canadian Pacific Railway may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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.
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