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 Micron Technology, Inc.'s (NASDAQ:MU) P/E ratio could help you assess the value on offer. Micron Technology has a P/E ratio of 5.31, based on the last twelve months. In other words, at today's prices, investors are paying $5.31 for every $1 in prior year profit.
How Do You Calculate Micron Technology's P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Micron Technology:
P/E of 5.31 = $47.49 ÷ $8.94 (Based on the trailing twelve months to May 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. 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 Micron Technology's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Micron Technology has a lower P/E than the average (23.1) P/E for companies in the semiconductor industry.
This suggests that market participants think Micron Technology will underperform other companies in its industry. 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
Earnings growth rates have a big influence on P/E ratios. When earnings grow, the 'E' increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Micron Technology'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 21%.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. 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.
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.
How Does Micron Technology's Debt Impact Its P/E Ratio?
Since Micron Technology holds net cash of US$1.8b, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Micron Technology's P/E Ratio
Micron Technology's P/E is 5.3 which is below average (18) in the US market. The recent drop in earnings per share would almost certainly temper expectations, 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.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.
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.