Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at AeroVironment, Inc.'s (NASDAQ:AVAV) P/E ratio and reflect on what it tells us about the company's share price. AeroVironment has a price to earnings ratio of 43.52, based on the last twelve months. That corresponds to an earnings yield of approximately 2.3%.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for AeroVironment:
P/E of 43.52 = USD71.75 ÷ USD1.65 (Based on the year to October 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.
Does AeroVironment Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. You can see in the image below that the average P/E (20.7) for companies in the aerospace & defense industry is lower than AeroVironment's P/E.
AeroVironment's P/E tells us that market participants think the company will perform better than its industry peers, going forward. 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.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. And in that case, the P/E ratio itself will drop rather quickly. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
AeroVironment saw earnings per share decrease by 15% last year. But over the longer term (5 years) earnings per share have increased by 24%.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. That means it doesn't take debt or cash into account. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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.
So What Does AeroVironment's Balance Sheet Tell Us?
With net cash of US$292m, AeroVironment has a very strong balance sheet, which may be important for its business. Having said that, at 17% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On AeroVironment's P/E Ratio
AeroVironment has a P/E of 43.5. That's higher than the average in its market, which is 18.9. Falling earnings per share is probably keeping traditional value investors away, but the healthy balance sheet means the company retains potential for future growth. If fails to eventuate, the current high P/E could prove to be temporary, as the share price falls.
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. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
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.
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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