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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 Telephone and Data Systems, Inc.'s (NYSE:TDS) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, Telephone and Data Systems has a P/E ratio of 21.61. That corresponds to an earnings yield of approximately 4.6%.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Telephone and Data Systems:
P/E of 21.61 = $29.71 ÷ $1.37 (Based on the year to March 2019.)
Is A High Price-to-Earnings Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. That isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. 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. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Telephone and Data Systems shrunk earnings per share by 1.3% last year. But it has grown its earnings per share by 23% per year over the last three years. And EPS is down 1.2% a year, over the last 5 years. So you wouldn't expect a very high P/E.
How Does Telephone and Data Systems's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Telephone and Data Systems has a lower P/E than the average (24) P/E for companies in the wireless telecom industry.
Telephone and Data Systems's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Since the market seems unimpressed with Telephone and Data Systems, 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.
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 Telephone and Data Systems's Balance Sheet Tell Us?
Net debt is 43% of Telephone and Data Systems's market cap. You'd want to be aware of this fact, but it doesn't bother us.
The Verdict On Telephone and Data Systems's P/E Ratio
Telephone and Data Systems's P/E is 21.6 which is above average (17.5) in the US market. With modest debt but no EPS growth in the last year, it's fair to say the P/E implies some optimism about future earnings, from the market.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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 report on the analyst consensus forecasts could help you make a master move on this stock.
But note: Telephone and Data Systems 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).
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 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. Thank you for reading.