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 AT&T Inc.'s (NYSE:T) P/E ratio could help you assess the value on offer. AT&T has a P/E ratio of 11.21, based on the last twelve months. That is equivalent to an earnings yield of about 8.9%.
How Do I Calculate AT&T's Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for AT&T:
P/E of 11.21 = $32.03 ÷ $2.86 (Based on the year to December 2018.)
Is A High P/E 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. Earnings growth means that in the future the 'E' will be higher. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
AT&T shrunk earnings per share by 40% over the last year. But EPS is up 6.4% over the last 3 years. And EPS is down 3.6% a year, over the last 5 years. This growth rate might warrant a below average P/E ratio.
Does AT&T Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio indicates whether the market has higher or lower expectations of a company. We can see in the image below that the average P/E (18.8) for companies in the telecom industry is higher than AT&T's P/E.
AT&T's P/E tells us that market participants think it will not fare as well as its peers in the same industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. 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
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. 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.
So What Does AT&T's Balance Sheet Tell Us?
AT&T's net debt is 75% of its market cap. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.
The Verdict On AT&T's P/E Ratio
AT&T has a P/E of 11.2. That's below the average in the US market, which is 18.2. When you consider that the company has significant debt, and didn't grow EPS last year, it isn't surprising that the market has muted expectations.
Investors should be looking to buy stocks that the market is wrong about. 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 AT&T. So you may wish to see this free collection of other companies that have grown earnings strongly.
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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.