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 Chubb Limited's (NYSE:CB) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, Chubb has a P/E ratio of 12.96. In other words, at today's prices, investors are paying $12.96 for every $1 in prior year profit.
How Do I Calculate Chubb's Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Chubb:
P/E of 12.96 = $104.610 ÷ $8.072 (Based on the year to March 2020.)
(Note: the above calculation results may not be precise due to rounding.)
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. 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 Chubb's P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. You can see in the image below that the average P/E (13.0) for companies in the insurance industry is roughly the same as Chubb's P/E.
Its P/E ratio suggests that Chubb shareholders think that in the future it will perform about the same as other companies in its industry classification. If the company has better than average prospects, then the market might be underestimating it. Further research into factors such as insider buying and selling, could help you form your own view on whether that is likely.
How Growth Rates Impact P/E Ratios
Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means even if the current P/E is low, it will increase over time if the share price stays flat. Then, a higher P/E might scare off shareholders, pushing the share price down.
Chubb saw earnings per share decrease by 4.9% last year. And EPS is down 7.6% a year, over the last 3 years. So it would be surprising to see a high P/E.
Remember: P/E Ratios Don't Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
So What Does Chubb's Balance Sheet Tell Us?
Chubb's net debt equates to 27% of its market capitalization. You'd want to be aware of this fact, but it doesn't bother us.
The Verdict On Chubb's P/E Ratio
Chubb's P/E is 13.0 which is below average (14.8) in the US market. Since it only carries a modest debt load, it's likely the low expectations implied by the P/E ratio arise from the lack of recent earnings growth.
Investors have an opportunity when market expectations about a stock are wrong. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. 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 Chubb. 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).
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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned. Thank you for reading.