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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how The Cato Corporation's (NYSE:CATO) P/E ratio could help you assess the value on offer. Cato has a P/E ratio of 10.78, based on the last twelve months. In other words, at today's prices, investors are paying $10.78 for every $1 in prior year profit.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Cato:
P/E of 10.78 = $12.39 ÷ $1.15 (Based on the year to May 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. 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
When earnings fall, the 'E' decreases, over time. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.
Cato's earnings made like a rocket, taking off 199% last year. Unfortunately, earnings per share are down 8.9% a year, over 5 years.
Does Cato Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. If you look at the image below, you can see Cato has a lower P/E than the average (14.1) in the specialty retail industry classification.
Cato'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 Cato, 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.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
Don't forget that the P/E ratio considers market capitalization. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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 Cato's P/E?
Cato has net cash of US$19m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Verdict On Cato's P/E Ratio
Cato has a P/E of 10.8. That's below the average in the US market, which is 17. Not only should the net cash position reduce risk, but the recent growth has been impressive. The relatively low P/E ratio implies the market is pessimistic.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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. Although we don't have analyst forecasts, shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
Of course you might be able to find a better stock than Cato. So you may wish to see this free collection of other companies that have grown earnings strongly.
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.