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Why ALLETE, Inc.'s (NYSE:ALE) High P/E Ratio Isn't Necessarily A Bad Thing

Simply Wall St

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Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at ALLETE, Inc.'s (NYSE:ALE) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, ALLETE has a P/E ratio of 22.03. That corresponds to an earnings yield of approximately 4.5%.

View our latest analysis for ALLETE

How Do You Calculate A P/E Ratio?

The formula for P/E is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for ALLETE:

P/E of 22.03 = $82.99 ÷ $3.77 (Based on the trailing twelve months to March 2019.)

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 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

P/E ratios primarily reflect market expectations around earnings growth rates. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

It's great to see that ALLETE grew EPS by 10% in the last year. And its annual EPS growth rate over 5 years is 7.5%. With that performance, you might expect an above average P/E ratio.

Does ALLETE 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. You can see in the image below that the average P/E (21.8) for companies in the electric utilities industry is roughly the same as ALLETE's P/E.

NYSE:ALE Price Estimation Relative to Market, May 14th 2019

ALLETE's P/E tells us that market participants think its prospects are roughly in line with its industry. If the company has better than average prospects, then the market might be underestimating it. Further research into factors such asmanagement tenure, could help you form your own view on whether that is likely.

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. So it won't reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.

Is Debt Impacting ALLETE's P/E?

Net debt is 29% of ALLETE's market cap. While that's enough to warrant consideration, it doesn't really concern us.

The Bottom Line On ALLETE's P/E Ratio

ALLETE's P/E is 22 which is above average (17.8) in the US market. The company is not overly constrained by its modest debt levels, and its recent EPS growth very solid. So on this analysis it seems reasonable that its P/E ratio is above average.

Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

You might be able to find a better buy than ALLETE. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

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 editorial-team@simplywallst.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.