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Why Credit Acceptance Corporation's (NASDAQ:CACC) High P/E Ratio Isn't Necessarily A Bad Thing

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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 Credit Acceptance Corporation's (NASDAQ:CACC) P/E ratio and reflect on what it tells us about the company's share price. Credit Acceptance has a price to earnings ratio of 15.23, based on the last twelve months. That is equivalent to an earnings yield of about 6.6%.

See our latest analysis for Credit Acceptance

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for Credit Acceptance:

P/E of 15.23 = $487.35 ÷ $31.99 (Based on the year to March 2019.)

Is A High P/E 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.

Does Credit Acceptance 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. You can see in the image below that the average P/E (9.7) for companies in the consumer finance industry is lower than Credit Acceptance's P/E.

NasdaqGS:CACC Price Estimation Relative to Market, July 16th 2019

Its relatively high P/E ratio indicates that Credit Acceptance 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

Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. Earnings growth means that in the future the 'E' will be higher. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Credit Acceptance increased earnings per share by a whopping 25% last year. And earnings per share have improved by 26% annually, over the last five years. I'd therefore be a little surprised if its P/E ratio was not relatively high.

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

The 'Price' in P/E reflects the market capitalization of the company. 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.

How Does Credit Acceptance's Debt Impact Its P/E Ratio?

Credit Acceptance's net debt equates to 45% of its market capitalization. While it's worth keeping this in mind, it isn't a worry.

The Verdict On Credit Acceptance's P/E Ratio

Credit Acceptance has a P/E of 15.2. That's below the average in the US market, which is 18. The company does have a little debt, and EPS growth was good last year. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.

Investors should be looking to buy stocks that the market is wrong about. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

You might be able to find a better buy than Credit Acceptance. 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.