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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll show how you can use Advance Auto Parts, Inc.'s (NYSE:AAP) P/E ratio to inform your assessment of the investment opportunity. Advance Auto Parts has a P/E ratio of 30.75, based on the last twelve months. That corresponds to an earnings yield of approximately 3.3%.
How Do I Calculate Advance Auto Parts'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 Advance Auto Parts:
P/E of 30.75 = $176.78 ÷ $5.75 (Based on the year to December 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each $1 the company has earned over the last year. 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
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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Advance Auto Parts shrunk earnings per share by 10% over the last year. But it has grown its earnings per share by 2.1% per year over the last three years.
How Does Advance Auto Parts's P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. As you can see below, Advance Auto Parts has a higher P/E than the average company (15.4) in the specialty retail industry.
Its relatively high P/E ratio indicates that Advance Auto Parts shareholders think it will perform better than other companies in its industry classification. Shareholders are clearly optimistic, but the future is always uncertain. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. That means it doesn't take debt or cash into account. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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.
Is Debt Impacting Advance Auto Parts's P/E?
Advance Auto Parts has net debt worth just 1.2% of its market capitalization. The market might award it a higher P/E ratio if it had net cash, but its unlikely this low level of net borrowing is having a big impact on the P/E multiple.
The Bottom Line On Advance Auto Parts's P/E Ratio
Advance Auto Parts has a P/E of 30.8. That's higher than the average in the US market, which is 18.1. With some debt but no EPS growth last year, the market has high expectations of future profits.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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 report on the analyst consensus forecasts could help you make a master move on this stock.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E 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 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.