Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how Linamar Corporation's (TSE:LNR) P/E ratio could help you assess the value on offer. Linamar has a price to earnings ratio of 5.77, based on the last twelve months. In other words, at today's prices, investors are paying CA$5.77 for every CA$1 in prior year profit.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Linamar:
P/E of 5.77 = CA$44.66 ÷ CA$7.74 (Based on the year to September 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 Does Linamar'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 Linamar has a lower P/E than the average (13.7) P/E for companies in the auto components industry.
Its relatively low P/E ratio indicates that Linamar 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. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Linamar's earnings per share fell by 16% in the last twelve months. But over the longer term (5 years) earnings per share have increased by 9.6%.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. That means it doesn't take debt or cash into account. 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 spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
Is Debt Impacting Linamar's P/E?
Net debt totals 66% of Linamar'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 Linamar's P/E Ratio
Linamar has a P/E of 5.8. That's below the average in the CA market, which is 14.7. The P/E reflects market pessimism that probably arises from the lack of recent EPS growth, paired with significant leverage.
Investors have an opportunity when market expectations about a stock are wrong. 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.
But note: Linamar may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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.
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