Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at Snap-on Incorporated's (NYSE:SNA) P/E ratio and reflect on what it tells us about the company's share price. Snap-on has a price to earnings ratio of 12.86, based on the last twelve months. That means that at current prices, buyers pay $12.86 for every $1 in trailing yearly profits.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Snap-on:
P/E of 12.86 = $155.26 ÷ $12.08 (Based on the trailing twelve months to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the 'E' will be higher. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Snap-on increased earnings per share by an impressive 24% over the last twelve months. And it has bolstered its earnings per share by 15% per year over the last five years. So one might expect an above average P/E ratio.
How Does Snap-on's P/E Ratio Compare To Its Peers?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. If you look at the image below, you can see Snap-on has a lower P/E than the average (21.1) in the machinery industry classification.
Snap-on's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Since the market seems unimpressed with Snap-on, it's quite possible it could surprise on the upside. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
Remember: P/E Ratios Don't Consider The Balance Sheet
Don't forget that the P/E ratio considers market capitalization. So it won't reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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 Snap-on's Balance Sheet Tell Us?
Snap-on's net debt is 12% of its market cap. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.
The Bottom Line On Snap-on's P/E Ratio
Snap-on's P/E is 12.9 which is below average (18.1) in the US market. The company hasn't stretched its balance sheet, and earnings growth was good last year. The low P/E ratio suggests current market expectations are muted, implying these levels of growth will not continue.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. 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 find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E 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 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. Thank you for reading.