This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Deere & Company’s (NYSE:DE) P/E ratio could help you assess the value on offer. Deere has a price to earnings ratio of 15.04, based on the last twelve months. In other words, at today’s prices, investors are paying $15.04 for every $1 in prior year profit.
How Do You Calculate Deere’s P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Deere:
P/E of 15.04 = $159.14 ÷ $10.58 (Based on the year to January 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 isn’t necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. 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. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
It’s nice to see that Deere grew EPS by a stonking 137% in the last year. And earnings per share have improved by 19% annually, over the last three years. I’d therefore be a little surprised if its P/E ratio was not relatively high. But earnings per share are down 5.8% per year over the last five years.
How Does Deere’s P/E Ratio Compare To Its Peers?
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 Deere has a lower P/E than the average (20.6) in the machinery industry classification.
This suggests that market participants think Deere will underperform other companies in its industry. Since the market seems unimpressed with Deere, 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.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The ‘Price’ in P/E reflects the market capitalization of the company. 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.
How Does Deere’s Debt Impact Its P/E Ratio?
Deere has net debt worth 80% of its market capitalization. This is a reasonably significant level of debt — all else being equal you’d expect a much lower P/E than if it had net cash.
The Bottom Line On Deere’s P/E Ratio
Deere’s P/E is 15 which is below average (17.5) in the US market. The company has a meaningful amount of debt on the balance sheet, but that should not eclipse the solid earnings growth. The low P/E ratio suggests current market expectations are muted, implying these levels of growth will not continue.
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. 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.
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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.