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 Investors Title Company's (NASDAQ:ITIC) P/E ratio could help you assess the value on offer. Investors Title has a price to earnings ratio of 11.55, based on the last twelve months. In other words, at today's prices, investors are paying $11.55 for every $1 in prior year profit.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Investors Title:
P/E of 11.55 = $140.09 ÷ $12.13 (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. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.
How Does Investors Title's P/E Ratio Compare To Its Peers?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. If you look at the image below, you can see Investors Title has a lower P/E than the average (15.7) in the insurance industry classification.
Its relatively low P/E ratio indicates that Investors Title 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. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
How Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.
Investors Title saw earnings per share decrease by 14% last year. But over the longer term (5 years) earnings per share have increased by 16%.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. So it won't reflect the advantage of cash, or disadvantage of debt. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
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).
So What Does Investors Title's Balance Sheet Tell Us?
With net cash of US$56m, Investors Title has a very strong balance sheet, which may be important for its business. Having said that, at 21% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Verdict On Investors Title's P/E Ratio
Investors Title has a P/E of 11.6. That's below the average in the US market, which is 17.2. The recent drop in earnings per share would make investors cautious, the healthy balance sheet means the company retains potential for future growth. If that occurs, the current low P/E could prove to be temporary.
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.' We don't have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than Investors Title. 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).
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.