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 Donaldson Company, Inc.'s (NYSE:DCI) P/E ratio could help you assess the value on offer. Based on the last twelve months, Donaldson Company's P/E ratio is 25.36. That is equivalent to an earnings yield of about 3.9%.
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 Donaldson Company:
P/E of 25.36 = $52.82 ÷ $2.08 (Based on the trailing twelve months to July 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 Does Donaldson Company's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (20.6) for companies in the machinery industry is lower than Donaldson Company's P/E.
Its relatively high P/E ratio indicates that Donaldson Company shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. And in that case, the P/E ratio itself will drop rather quickly. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Donaldson Company's 51% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. Having said that, if we look back three years, EPS growth has averaged a comparatively less impressive 13%.
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. Thus, the metric does not reflect cash or debt held by the company. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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.
How Does Donaldson Company's Debt Impact Its P/E Ratio?
Donaldson Company's net debt is 6.8% of its market cap. So it doesn't have as many options as it would with net cash, but its debt would not have much of an impact on its P/E ratio.
The Verdict On Donaldson Company's P/E Ratio
Donaldson Company has a P/E of 25.4. That's higher than the average in its market, which is 18.1. Its debt levels do not imperil its balance sheet and its EPS growth is very healthy indeed. So on this analysis a high P/E ratio seems reasonable.
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 visual report on analyst forecasts could hold the key to an excellent investment decision.
But note: Donaldson Company 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).
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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.