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 Magellan Aerospace Corporation's (TSE:MAL) P/E ratio could help you assess the value on offer. Based on the last twelve months, Magellan Aerospace's P/E ratio is 9.97. That is equivalent to an earnings yield of about 10.0%.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Magellan Aerospace:
P/E of 9.97 = CA$15.00 ÷ CA$1.50 (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 CA$1 of company earnings. 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 Magellan Aerospace'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 Magellan Aerospace has a lower P/E than the average (21.4) in the aerospace & defense industry classification.
This suggests that market participants think Magellan Aerospace will underperform other companies in its industry. Many investors like to buy stocks when the market is pessimistic about their prospects. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
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.
Magellan Aerospace shrunk earnings per share by 4.2% last year. But it has grown its earnings per share by 9.6% per year over the last five years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. 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 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.
Magellan Aerospace's Balance Sheet
Magellan Aerospace has net debt worth just 2.8% of its market capitalization. It would probably trade on a higher P/E ratio if it had a lot of cash, but I doubt it is having a big impact.
The Verdict On Magellan Aerospace's P/E Ratio
Magellan Aerospace trades on a P/E ratio of 10.0, which is below the CA market average of 15.1. 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 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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
But note: Magellan Aerospace 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 firstname.lastname@example.org. 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.
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. Thank you for reading.