Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how Albemarle Corporation's (NYSE:ALB) P/E ratio could help you assess the value on offer. Based on the last twelve months, Albemarle's P/E ratio is 10.45. That corresponds to an earnings yield of approximately 9.6%.
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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 Albemarle:
P/E of 10.45 = $67.76 ÷ $6.49 (Based on the year to March 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 is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
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. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
In the last year, Albemarle grew EPS like Taylor Swift grew her fan base back in 2010; the 430% gain was both fast and well deserved. And earnings per share have improved by 16% annually, over the last three years. So we'd absolutely expect it to have a relatively high P/E ratio.
Does Albemarle 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. The image below shows that Albemarle has a lower P/E than the average (18.2) P/E for companies in the chemicals industry.
This suggests that market participants think Albemarle will underperform other companies in its industry. Since the market seems unimpressed with Albemarle, it's quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
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. 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 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.
Is Debt Impacting Albemarle's P/E?
Albemarle has net debt worth 21% of its market capitalization. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.
The Bottom Line On Albemarle's P/E Ratio
Albemarle trades on a P/E ratio of 10.4, which is below the US market average of 17.7. The company hasn't stretched its balance sheet, and earnings growth was good last year. If it continues to grow, then the current low P/E may prove to be unjustified.
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.
Of course you might be able to find a better stock than Albemarle. So you may wish to see this free collection of other companies that have grown earnings strongly.
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.