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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we’ll show how NorthWestern Corporation’s (NYSE:NWE) P/E ratio could help you assess the value on offer. NorthWestern has a P/E ratio of 16.51, based on the last twelve months. That means that at current prices, buyers pay $16.51 for every $1 in trailing yearly profits.
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 NorthWestern:
P/E of 16.51 = $65.06 ÷ $3.94 (Based on the trailing twelve months to December 2018.)
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. 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.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. When earnings grow, the ‘E’ increases, over time. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.
NorthWestern increased earnings per share by an impressive 18% over the last twelve months. And it has bolstered its earnings per share by 7.2% per year over the last five years. This could arguably justify a relatively high P/E ratio.
How Does NorthWestern’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that NorthWestern has a lower P/E than the average (19.5) P/E for companies in the integrated utilities industry.
Its relatively low P/E ratio indicates that NorthWestern shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with NorthWestern, it’s quite possible it could surprise on the upside. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
Don’t forget that the P/E ratio considers market capitalization. That means it doesn’t take debt or cash into account. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
How Does NorthWestern’s Debt Impact Its P/E Ratio?
NorthWestern has net debt worth 62% of its market capitalization. This is enough debt that you’d have to make some adjustments before using the P/E ratio to compare it to a company with net cash.
The Bottom Line On NorthWestern’s P/E Ratio
NorthWestern has a P/E of 16.5. That’s around the same as the average in the US market, which is 17. While it does have meaningful debt levels, it has also produced strong earnings growth recently. The P/E suggests the market isn’t confident that growth will be sustained, though.
Investors should be looking to buy stocks that the market is wrong about. 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 they key to an excellent investment decision.
But note: NorthWestern 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).
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.