This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to AVX Corporation's (NYSE:AVX), to help you decide if the stock is worth further research. What is AVX's P/E ratio? Well, based on the last twelve months it is 11.36. That means that at current prices, buyers pay $11.36 for every $1 in trailing yearly profits.
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 AVX:
P/E of 11.36 = $15.60 ÷ $1.37 (Based on the year to September 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. 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 Does AVX's P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. We can see in the image below that the average P/E (20.2) for companies in the electronic industry is higher than AVX's P/E.
This suggests that market participants think AVX will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. When earnings grow, the 'E' increases, over time. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
AVX's 247% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. And earnings per share have improved by 35% annually, over the last three years. So you might say it really deserves to have an above-average P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. 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 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.
AVX's Balance Sheet
With net cash of US$761m, AVX has a very strong balance sheet, which may be important for its business. Having said that, at 29% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Verdict On AVX's P/E Ratio
AVX has a P/E of 11.4. That's below the average in the US market, which is 18.0. It grew its EPS nicely over the last year, and the healthy balance sheet implies there is more potential for growth. The below average P/E ratio suggests that market participants don't believe the strong growth will continue.
Investors have an opportunity when market expectations about a stock are wrong. 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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
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 email@example.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.