Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!
The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll show how you can use AeroVironment, Inc.'s (NASDAQ:AVAV) P/E ratio to inform your assessment of the investment opportunity. Looking at earnings over the last twelve months, AeroVironment has a P/E ratio of 27.95. That is equivalent to an earnings yield of about 3.6%.
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 AeroVironment:
P/E of 27.95 = $65.84 ÷ $2.36 (Based on the trailing twelve months to January 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. 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 Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. Earnings growth means that in the future the 'E' will be higher. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Notably, AeroVironment grew EPS by a whopping 47% in the last year. And its annual EPS growth rate over 5 years is 61%. With that performance, I would expect it to have an above average P/E ratio.
Does AeroVironment Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (22) for companies in the aerospace & defense industry is lower than AeroVironment's P/E.
That means that the market expects AeroVironment will outperform other companies in its industry. Shareholders are clearly optimistic, but the future is always uncertain. So investors should delve deeper. I like to check if company insiders have been buying or selling.
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.
So What Does AeroVironment's Balance Sheet Tell Us?
With net cash of US$294m, AeroVironment has a very strong balance sheet, which may be important for its business. Having said that, at 19% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Verdict On AeroVironment's P/E Ratio
AeroVironment has a P/E of 27.9. That's higher than the average in the US market, which is 18. Its net cash position is the cherry on top of its superb EPS growth. So based on this analysis we'd expect AeroVironment to have a high P/E ratio.
Investors have an opportunity when market expectations about a stock are wrong. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
Of course you might be able to find a better stock than AeroVironment. So you may wish to see this free collection of other companies that have grown earnings strongly.
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.