The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at Allison Transmission Holdings, Inc.'s (NYSE:ALSN) P/E ratio and reflect on what it tells us about the company's share price. Allison Transmission Holdings has a price to earnings ratio of 9.1, based on the last twelve months. In other words, at today's prices, investors are paying $9.1 for every $1 in prior year profit.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Allison Transmission Holdings:
P/E of 9.1 = $45.92 ÷ $5.05 (Based on the trailing twelve months to March 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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 Allison Transmission Holdings's P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Allison Transmission Holdings has a lower P/E than the average (21) P/E for companies in the machinery industry.
Allison Transmission Holdings's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Since the market seems unimpressed with Allison Transmission Holdings, it's quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
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. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.
It's nice to see that Allison Transmission Holdings grew EPS by a stonking 27% in the last year. And its annual EPS growth rate over 5 years is 37%. With that performance, I would expect it to have an above average 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 Allison Transmission Holdings's Balance Sheet Tell Us?
Allison Transmission Holdings has net debt equal to 40% of its market cap. You'd want to be aware of this fact, but it doesn't bother us.
The Verdict On Allison Transmission Holdings's P/E Ratio
Allison Transmission Holdings's P/E is 9.1 which is below average (17.9) in the US market. 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. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
You might be able to find a better buy than Allison Transmission Holdings. 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 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.