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Here's How P/E Ratios Can Help Us Understand American Equity Investment Life Holding Company (NYSE:AEL)

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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 look at American Equity Investment Life Holding Company's (NYSE:AEL) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, American Equity Investment Life Holding has a P/E ratio of 8.52. That is equivalent to an earnings yield of about 12%.

Check out our latest analysis for American Equity Investment Life Holding

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for American Equity Investment Life Holding:

P/E of 8.52 = $27 ÷ $3.17 (Based on the year to March 2019.)

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. 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 American Equity Investment Life Holding's P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. We can see in the image below that the average P/E (17.4) for companies in the insurance industry is higher than American Equity Investment Life Holding's P/E.

NYSE:AEL Price Estimation Relative to Market, July 12th 2019

Its relatively low P/E ratio indicates that American Equity Investment Life Holding shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with American Equity Investment Life Holding, it's quite possible it could surprise on the upside. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

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. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means even if the current P/E is high, it will reduce over time if the share price stays flat. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

American Equity Investment Life Holding's earnings per share grew by -8.2% in the last twelve months. And it has improved its earnings per share by 15% per year over the last three years.

Remember: P/E Ratios Don't Consider The Balance Sheet

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. 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.

How Does American Equity Investment Life Holding's Debt Impact Its P/E Ratio?

Since American Equity Investment Life Holding holds net cash of US$135m, it can spend on growth, justifying a higher P/E ratio than otherwise.

The Verdict On American Equity Investment Life Holding's P/E Ratio

American Equity Investment Life Holding has a P/E of 8.5. That's below the average in the US market, which is 17.9. EPS was up modestly better over the last twelve months. Also positive, the relatively strong balance sheet will allow for investment in growth. In contrast, the P/E indicates shareholders doubt that will happen!

Investors should be looking to buy stocks that the market is wrong about. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.

But note: American Equity Investment Life Holding 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).

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.