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 A. O. Smith Corporation's (NYSE:AOS) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, A. O. Smith has a P/E ratio of 17.91. That corresponds to an earnings yield of approximately 5.6%.
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 A. O. Smith:
P/E of 17.91 = $44.85 ÷ $2.5 (Based on the trailing twelve months to June 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each $1 the company has earned over the last year. That isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
Does A. O. Smith 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. As you can see below A. O. Smith has a P/E ratio that is fairly close for the average for the building industry, which is 18.
Its P/E ratio suggests that A. O. Smith shareholders think that in the future it will perform about the same as other companies in its industry classification. If the company has better than average prospects, then the market might be underestimating it. I would further inform my view by checking insider buying and selling., among other things.
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. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.
Notably, A. O. Smith grew EPS by a whopping 30% in the last year. And it has bolstered its earnings per share by 19% per year over the last five years. So we'd generally expect it to have a relatively high P/E ratio.
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.
So What Does A. O. Smith's Balance Sheet Tell Us?
The extra options and safety that comes with A. O. Smith's US$219m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Bottom Line On A. O. Smith's P/E Ratio
A. O. Smith trades on a P/E ratio of 17.9, which is fairly close to the US market average of 17.1. Its net cash position is the cherry on top of its superb EPS growth. So based on this analysis we'd expect A. O. Smith to have a higher P/E ratio.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
You might be able to find a better buy than A. O. Smith. 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).
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 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.