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Here's How P/E Ratios Can Help Us Understand Taylor Wimpey plc (LON:TW.)

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This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Taylor Wimpey plc's (LON:TW.), to help you decide if the stock is worth further research. Taylor Wimpey has a P/E ratio of 7.76, based on the last twelve months. That means that at current prices, buyers pay £7.76 for every £1 in trailing yearly profits.

Check out our latest analysis for Taylor Wimpey

How Do I Calculate A Price To Earnings Ratio?

The formula for P/E is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Taylor Wimpey:

P/E of 7.76 = £1.56 ÷ £0.20 (Based on the year to December 2018.)

Is A High P/E Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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.

How Growth Rates Impact P/E Ratios

Probably the most important factor in determining what P/E a company trades on is the earnings growth. Earnings growth means that in the future the 'E' will be higher. 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.

Most would be impressed by Taylor Wimpey earnings growth of 18% in the last year. And it has bolstered its earnings per share by 22% per year over the last five years. So one might expect an above average P/E ratio.

How Does Taylor Wimpey'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 Taylor Wimpey has a lower P/E than the average (9.8) in the consumer durables industry classification.

LSE:TW. Price Estimation Relative to Market, June 26th 2019

Its relatively low P/E ratio indicates that Taylor Wimpey shareholders think it will struggle to do as well as other companies in its industry classification. 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.

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.

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 Taylor Wimpey's P/E?

Taylor Wimpey has net cash of UK£644m. This is fairly high at 13% of its market capitalization. That might mean balance sheet strength is important to the business, but should also help push the P/E a bit higher than it would otherwise be.

The Verdict On Taylor Wimpey's P/E Ratio

Taylor Wimpey has a P/E of 7.8. That's below the average in the GB market, which is 16.3. It grew its EPS nicely over the last year, and the healthy balance sheet implies there is more potential for growth. The relatively low P/E ratio implies the market is pessimistic.

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.

Of course you might be able to find a better stock than Taylor Wimpey. 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 editorial-team@simplywallst.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.