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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Eastman Chemical Company's (NYSE:EMN), to help you decide if the stock is worth further research. Looking at earnings over the last twelve months, Eastman Chemical has a P/E ratio of 10.72. In other words, at today's prices, investors are paying $10.72 for every $1 in prior year profit.
How Do I Calculate Eastman Chemical's Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Eastman Chemical:
P/E of 10.72 = $76.37 ÷ $7.12 (Based on the trailing twelve months to March 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 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. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. 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.
Eastman Chemical shrunk earnings per share by 27% over the last year. But it has grown its earnings per share by 4.4% per year over the last three years. And over the longer term (5 years) earnings per share have decreased 1.1% annually. This growth rate might warrant a below average P/E ratio.
How Does Eastman Chemical's P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Eastman Chemical has a lower P/E than the average (18.2) P/E for companies in the chemicals industry.
Its relatively low P/E ratio indicates that Eastman Chemical shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Eastman Chemical, it's quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
Remember: P/E Ratios Don't Consider The Balance Sheet
Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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.
Eastman Chemical's Balance Sheet
Net debt totals 59% of Eastman Chemical's market cap. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.
The Bottom Line On Eastman Chemical's P/E Ratio
Eastman Chemical trades on a P/E ratio of 10.7, which is below the US market average of 17.8. The P/E reflects market pessimism that probably arises from the lack of recent EPS growth, paired with significant leverage.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.
You might be able to find a better buy than Eastman Chemical. 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.