This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we'll show how Southwestern Energy Company's (NYSE:SWN) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, Southwestern Energy has a P/E ratio of 1.12. In other words, at today's prices, investors are paying $1.12 for every $1 in prior year profit.
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 Southwestern Energy:
P/E of 1.12 = $2.23 ÷ $1.99 (Based on the trailing twelve months to September 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 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 Does Southwestern Energy's P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. If you look at the image below, you can see Southwestern Energy has a lower P/E than the average (10.2) in the oil and gas industry classification.
Southwestern Energy'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 Southwestern Energy, 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.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
In the last year, Southwestern Energy grew EPS like Taylor Swift grew her fan base back in 2010; the 125% gain was both fast and well deserved. Regrettably, the longer term performance is poor, with EPS down 1.5% per year over 5 years.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn't take debt or cash into account. 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.
How Does Southwestern Energy's Debt Impact Its P/E Ratio?
Net debt totals a substantial 186% of Southwestern Energy's market cap. This is a relatively high level of debt, so the stock probably deserves a relatively low P/E ratio. Keep that in mind when comparing it to other companies.
The Bottom Line On Southwestern Energy's P/E Ratio
Southwestern Energy's P/E is 1.1 which is below average (17.9) in the US market. While the EPS growth last year was strong, the significant debt levels reduce the number of options available to management. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.
Investors have an opportunity when market expectations about a stock are wrong. 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 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 Southwestern Energy. So you may wish to see this free collection of other companies that have grown earnings strongly.
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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.