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 Forward Air Corporation's (NASDAQ:FWRD) P/E ratio could help you assess the value on offer. Based on the last twelve months, Forward Air's P/E ratio is 19.88. That is equivalent to an earnings yield of about 5.0%.
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 Forward Air:
P/E of 19.88 = $62.3 ÷ $3.13 (Based on the trailing twelve months to June 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each $1 the company has earned over the last year. 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 Forward Air's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Forward Air has a lower P/E than the average (21.8) P/E for companies in the logistics industry.
Its relatively low P/E ratio indicates that Forward Air shareholders think it will struggle to do as well as other companies in its industry classification. Many investors like to buy stocks when the market is pessimistic about their prospects. You should delve deeper. I like to check if company insiders have been buying or 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. 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. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Forward Air saw earnings per share decrease by 1.9% last year. But over the longer term (5 years) earnings per share have increased by 11%.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
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. 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.
Forward Air's Balance Sheet
Net debt totals just 2.4% of Forward Air's market cap. The market might award it a higher P/E ratio if it had net cash, but its unlikely this low level of net borrowing is having a big impact on the P/E multiple.
The Verdict On Forward Air's P/E Ratio
Forward Air has a P/E of 19.9. That's higher than the average in its market, which is 17.3. With modest debt but no EPS growth in the last year, it's fair to say the P/E implies some optimism about future earnings, from the market.
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 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 Forward Air. 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 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.