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 LGI Homes, Inc.'s (NASDAQ:LGIH) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, LGI Homes has a P/E ratio of 10.68. That is equivalent to an earnings yield of about 9.4%.
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 LGI Homes:
P/E of 10.68 = $72.50 ÷ $6.79 (Based on the year to September 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 isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.
Does LGI Homes 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. The image below shows that LGI Homes has a lower P/E than the average (13.7) P/E for companies in the consumer durables industry.
This suggests that market participants think LGI Homes 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
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. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.
LGI Homes maintained roughly steady earnings over the last twelve months. But EPS is up 57% over the last 5 years.
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. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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).
So What Does LGI Homes's Balance Sheet Tell Us?
LGI Homes has net debt equal to 43% of its market cap. While it's worth keeping this in mind, it isn't a worry.
The Bottom Line On LGI Homes's P/E Ratio
LGI Homes has a P/E of 10.7. That's below the average in the US market, which is 18.2. The company does have a little debt, and EPS is moving in the right direction. If growth is sustainable over the long term, then the current P/E ratio may be a sign of good value.
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.
You might be able to find a better buy than LGI 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).
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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