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Is Cummins Inc.'s (NYSE:CMI) P/E Ratio Really That Good?

Simply Wall St

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at Cummins Inc.'s (NYSE:CMI) P/E ratio and reflect on what it tells us about the company's share price. Cummins has a price to earnings ratio of 9.90, based on the last twelve months. In other words, at today's prices, investors are paying $9.90 for every $1 in prior year profit.

Check out our latest analysis for Cummins

How Do You Calculate Cummins's P/E Ratio?

The formula for P/E is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Cummins:

P/E of 9.90 = $162.76 ÷ $16.44 (Based on the year to June 2019.)

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. 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 Does Cummins's P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. If you look at the image below, you can see Cummins has a lower P/E than the average (19.7) in the machinery industry classification.

NYSE:CMI Price Estimation Relative to Market, October 14th 2019

Its relatively low P/E ratio indicates that Cummins shareholders think it will struggle to do as well as other companies in its industry classification. Many investors like to buy stocks when the market is pessimistic about their prospects. You should delve deeper. I like to check if company insiders have been buying or selling.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. 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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Cummins's earnings made like a rocket, taking off 159% last year. Even better, EPS is up 31% per year over three years. So we'd absolutely expect it to have a relatively high P/E ratio.

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. So it won't reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

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).

So What Does Cummins's Balance Sheet Tell Us?

Cummins's net debt is 1.4% of its market cap. It would probably trade on a higher P/E ratio if it had a lot of cash, but I doubt it is having a big impact.

The Bottom Line On Cummins's P/E Ratio

Cummins has a P/E of 9.9. That's below the average in the US market, which is 17.5. The EPS growth last year was strong, and debt levels are quite reasonable. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.

Investors should be looking to buy stocks that the market is wrong about. 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 report on the analyst consensus forecasts could help you make a master move on this stock.

But note: Cummins 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).

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 editorial-team@simplywallst.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.