The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at The Goodyear Tire & Rubber Company's (NASDAQ:GT) P/E ratio and reflect on what it tells us about the company's share price. Goodyear Tire & Rubber has a P/E ratio of 6.27, based on the last twelve months. That corresponds to an earnings yield of approximately 16%.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Goodyear Tire & Rubber:
P/E of 6.27 = $12.22 ÷ $1.95 (Based on the trailing twelve months 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. 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 Goodyear Tire & Rubber's P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. If you look at the image below, you can see Goodyear Tire & Rubber has a lower P/E than the average (15.3) in the auto components industry classification.
Its relatively low P/E ratio indicates that Goodyear Tire & Rubber shareholders think it will struggle to do as well as other companies in its industry classification. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. 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. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Goodyear Tire & Rubber's earnings made like a rocket, taking off 79% last year. And earnings per share have improved by 23% annually, over the last three years. So you might say it really deserves to have an above-average P/E ratio. Unfortunately, earnings per share are down 2.1% a year, over 5 years.
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. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
Is Debt Impacting Goodyear Tire & Rubber's P/E?
Goodyear Tire & Rubber has net debt worth a very significant 196% of its market capitalization. This level of debt justifies a relatively low P/E, so remain cognizant of the debt, if you're comparing it to other stocks.
The Bottom Line On Goodyear Tire & Rubber's P/E Ratio
Goodyear Tire & Rubber has a P/E of 6.3. That's below the average in the US market, which is 17.4. The company may have significant debt, but EPS growth was good last year. The low P/E ratio suggests current market expectations are muted, implying these levels of growth will not continue.
Investors should be looking to buy stocks that the market is wrong about. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
But note: Goodyear Tire & Rubber 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).
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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.