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 AUDI AG's (ETR:NSU) P/E ratio could help you assess the value on offer. AUDI has a price to earnings ratio of 11.51, based on the last twelve months. In other words, at today's prices, investors are paying €11.51 for every €1 in prior year profit.
How Do I Calculate AUDI's Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for AUDI:
P/E of 11.51 = EUR808.00 ÷ EUR70.21 (Based on the year to June 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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.
Does AUDI Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. The image below shows that AUDI has a P/E ratio that is roughly in line with the auto industry average (10.8).
AUDI's P/E tells us that market participants think its prospects are roughly in line with its industry. So if AUDI actually outperforms its peers going forward, that should be a positive for the share price. Checking factors such as director buying and selling. could help you form your own view on if that will happen.
How Growth Rates Impact P/E Ratios
If earnings fall then in the future the 'E' will be lower. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
AUDI saw earnings per share decrease by 21% last year. And over the longer term (5 years) earnings per share have decreased 6.0% annually. This growth rate might warrant a below average P/E ratio.
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. That means it doesn't take debt or cash into account. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
AUDI's Balance Sheet
With net cash of €17b, AUDI has a very strong balance sheet, which may be important for its business. Having said that, at 49% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Verdict On AUDI's P/E Ratio
AUDI trades on a P/E ratio of 11.5, which is below the DE market average of 20.6. Falling earnings per share are likely to be keeping potential buyers away, the relatively strong balance sheet will allow the company time to invest in growth. If it achieves that, then there's real potential that the low P/E could eventually indicate undervaluation.
Investors have an opportunity when market expectations about a stock are wrong. 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. Although we don't have analyst forecasts shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than AUDI. 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).
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.
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