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Why CAE Inc.'s (TSE:CAE) High P/E Ratio Isn't Necessarily A Bad Thing

Simply Wall St

Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use CAE Inc.'s (TSE:CAE) P/E ratio to inform your assessment of the investment opportunity. What is CAE's P/E ratio? Well, based on the last twelve months it is 27.58. In other words, at today's prices, investors are paying CA$27.58 for every CA$1 in prior year profit.

See our latest analysis for CAE

How Do You Calculate A P/E Ratio?

The formula for P/E is:

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

Or for CAE:

P/E of 27.58 = CA$33.38 ÷ CA$1.21 (Based on the trailing twelve months 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 a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.

Does CAE 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. As you can see below, CAE has a higher P/E than the average company (21.9) in the aerospace & defense industry.

TSX:CAE Price Estimation Relative to Market, October 31st 2019

That means that the market expects CAE will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.

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 unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.

CAE shrunk earnings per share by 8.8% last year. But over the longer term (5 years) earnings per share have increased by 11%.

Remember: P/E Ratios Don't Consider The Balance Sheet

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. 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).

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.

CAE's Balance Sheet

Net debt totals 23% of CAE's market cap. That's enough debt to impact the P/E ratio a little; so keep it in mind if you're comparing it to companies without debt.

The Verdict On CAE's P/E Ratio

CAE's P/E is 27.6 which is above average (14.1) in its 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.

Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. 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.

But note: CAE 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 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.