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 Extended Stay America Inc’s (NASDAQ:STAY) P/E ratio to inform your assessment of the investment opportunity. Extended Stay America has a price to earnings ratio of 18.22, based on the last twelve months. That means that at current prices, buyers pay $18.22 for every $1 in trailing yearly profits.
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 Extended Stay America:
P/E of 18.22 = $18.38 ÷ $1.01 (Based on the trailing twelve months to September 2018.)
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. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
Most would be impressed by Extended Stay America earnings growth of 21% in the last year. And its annual EPS growth rate over 5 years is 13%. So one might expect an above average P/E ratio. But earnings per share are down 9.5% per year over the last three years.
How Does Extended Stay America’s P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Extended Stay America has a P/E ratio that is roughly in line with the hospitality industry average (17.7).
Its P/E ratio suggests that Extended Stay America shareholders think that in the future it will perform about the same as other companies in its industry classification. So if Extended Stay America actually outperforms its peers going forward, that should be a positive for the share price. I inform my view byby checking management tenure and remuneration, among other things.
Remember: P/E Ratios Don’t Consider The Balance Sheet
The ‘Price’ in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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).
Extended Stay America’s Balance Sheet
Net debt totals 69% of Extended Stay America’s market cap. 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 Extended Stay America’s P/E Ratio
Extended Stay America’s P/E is 18.2 which is about average (18.5) in the US market. The significant levels of debt do detract somewhat from the strong earnings growth. The P/E suggests the market isn’t confident that growth will be sustained, though.
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.
Of course you might be able to find a better stock than Extended Stay America. So you may wish to see this free collection of other companies that have grown earnings strongly.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.