This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Mercury General Corporation's (NYSE:MCY), to help you decide if the stock is worth further research. Looking at earnings over the last twelve months, Mercury General has a P/E ratio of 14.81. That corresponds to an earnings yield of approximately 6.8%.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Mercury General:
P/E of 14.81 = $52.41 ÷ $3.54 (Based on the trailing twelve months to June 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. 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.
Does Mercury General Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. As you can see below Mercury General has a P/E ratio that is fairly close for the average for the insurance industry, which is 15.6.
Mercury General's P/E tells us that market participants think its prospects are roughly in line with its industry. The company could surprise by performing better than average, in the future. Checking factors such as director buying and selling. could help you form your own view on if that will happen.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. When earnings grow, the 'E' increases, over time. 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, Mercury General grew EPS like Taylor Swift grew her fan base back in 2010; the 134% gain was both fast and well deserved. Even better, EPS is up 21% per year over three years. So you might say it really deserves to have an above-average P/E ratio. Regrettably, the longer term performance is poor, with EPS down 2.7% per year over 5 years.
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. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
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.
Mercury General's Balance Sheet
Since Mercury General holds net cash of US$229m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Mercury General's P/E Ratio
Mercury General's P/E is 14.8 which is below average (17.3) in the US market. It grew its EPS nicely over the last year, and the healthy balance sheet implies there is more potential for growth. One might conclude that the market is a bit pessimistic, given the low P/E ratio. Given analysts are expecting further growth, one I would have expected a higher P/E ratio. So this stock may well be worth further research.
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.
You might be able to find a better buy than Mercury General. 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).
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.
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.