This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll look at Southwest Airlines Co.'s (NYSE:LUV) P/E ratio and reflect on what it tells us about the company's share price. Southwest Airlines has a P/E ratio of 12.28, based on the last twelve months. In other words, at today's prices, investors are paying $12.28 for every $1 in prior year profit.
How Do You Calculate Southwest Airlines's P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Southwest Airlines:
P/E of 12.28 = $54.91 ÷ $4.47 (Based on the year to September 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. That isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Does Southwest Airlines'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. You can see in the image below that the average P/E (8.8) for companies in the airlines industry is lower than Southwest Airlines's P/E.
That means that the market expects Southwest Airlines will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So investors 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. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Southwest Airlines saw earnings per share decrease by 27% last year. But it has grown its earnings per share by 22% per year over the last five years.
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. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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 spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
Is Debt Impacting Southwest Airlines's P/E?
Since Southwest Airlines holds net cash of US$1.6b, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Southwest Airlines's P/E Ratio
Southwest Airlines's P/E is 12.3 which is below average (18.4) in the US market. The recent drop in earnings per share would almost certainly temper expectations, but the net cash position means the company has time to improve: if so, the low P/E could be an opportunity.
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 visual report on analyst forecasts could hold the key to an excellent investment decision.
But note: Southwest Airlines 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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