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 William Lyon Homes's (NYSE:WLH) P/E ratio could help you assess the value on offer. William Lyon Homes has a price to earnings ratio of 9.31, based on the last twelve months. That is equivalent to an earnings yield of about 11%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for William Lyon Homes:
P/E of 9.31 = $19.6 ÷ $2.11 (Based on the year to June 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. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
How Does William Lyon Homes's P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. We can see in the image below that the average P/E (12.8) for companies in the consumer durables industry is higher than William Lyon Homes's P/E.
William Lyon Homes's P/E tells us that market participants think it will not fare as well as its peers in the same industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. 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. When earnings grow, the 'E' increases, over time. And in that case, the P/E ratio itself will drop rather quickly. Then, a lower P/E should attract more buyers, pushing the share price up.
It's great to see that William Lyon Homes grew EPS by 13% in the last year. And it has improved its earnings per share by 7.6% per year over the last three years. So one might expect an above average P/E ratio. Unfortunately, earnings per share are down 15% a year, over 5 years.
Remember: P/E Ratios Don't Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. 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 William Lyon Homes's Debt Impact Its P/E Ratio?
William Lyon Homes's net debt is considerable, at 185% of its market cap. If you want to compare its P/E ratio to other companies, you must keep in mind that these debt levels would usually warrant a relatively low P/E.
The Bottom Line On William Lyon Homes's P/E Ratio
William Lyon Homes's P/E is 9.3 which is below average (18.2) in the US market. While the EPS growth last year was strong, the significant debt levels reduce the number of options available to management. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.
Investors should be looking to buy stocks that the market is wrong about. 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 William Lyon Homes. 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.