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Here's How P/E Ratios Can Help Us Understand Magna International Inc. (TSE:MG)

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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 show how you can use Magna International Inc.'s (TSE:MG) P/E ratio to inform your assessment of the investment opportunity. Looking at earnings over the last twelve months, Magna International has a P/E ratio of 5.7. That is equivalent to an earnings yield of about 18%.

See our latest analysis for Magna International

How Do I Calculate Magna International's Price To Earnings Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)

Or for Magna International:

P/E of 5.7 = $46.36 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $8.13 (Based on the year to March 2019.)

Is A High P/E Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing 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.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means unless the share price increases, the P/E will reduce in a few years. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

Magna International increased earnings per share by a whopping 31% last year. And its annual EPS growth rate over 5 years is 18%. I'd therefore be a little surprised if its P/E ratio was not relatively high.

Does Magna International 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. We can see in the image below that the average P/E (14.5) for companies in the auto components industry is higher than Magna International's P/E.

TSX:MG Price Estimation Relative to Market, June 14th 2019

Magna International's P/E tells us that market participants think it will not fare as well as its peers in the same industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. So it won't reflect the advantage of cash, or disadvantage of debt. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.

Magna International's Balance Sheet

Net debt totals 17% of Magna International's market cap. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.

The Bottom Line On Magna International's P/E Ratio

Magna International has a P/E of 5.7. That's below the average in the CA market, which is 15. The EPS growth last year was strong, and debt levels are quite reasonable. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.

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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

Of course you might be able to find a better stock than Magna International. 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.