The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at SLM Corporation's (NASDAQ:SLM) P/E ratio and reflect on what it tells us about the company's share price. SLM has a price to earnings ratio of 6.52, based on the last twelve months. That corresponds to an earnings yield of approximately 15.3%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for SLM:
P/E of 6.52 = $8.58 ÷ $1.32 (Based on the year 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. 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 SLM'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 (8.6) for companies in the consumer finance industry is higher than SLM's P/E.
This suggests that market participants think SLM will underperform other companies in its industry. Many investors like to buy stocks when the market is pessimistic about their prospects. You should delve deeper. I like to check if company insiders have been buying or selling.
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. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.
In the last year, SLM grew EPS like Taylor Swift grew her fan base back in 2010; the 53% gain was both fast and well deserved. The cherry on top is that the five year growth rate was an impressive 20% per year. With that kind of growth rate we would generally expect a high P/E ratio.
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. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
How Does SLM's Debt Impact Its P/E Ratio?
SLM's net debt equates to 29% of its market capitalization. You'd want to be aware of this fact, but it doesn't bother us.
The Bottom Line On SLM's P/E Ratio
SLM has a P/E of 6.5. That's below the average in the US market, which is 18.4. The company hasn't stretched its balance sheet, and earnings growth was good last year. 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. 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: SLM 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).
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.
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