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Should We Worry About CarMax, Inc.'s (NYSE:KMX) P/E Ratio?

Simply Wall St

The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to CarMax, Inc.'s (NYSE:KMX), to help you decide if the stock is worth further research. CarMax has a price to earnings ratio of 16.75, based on the last twelve months. That means that at current prices, buyers pay $16.75 for every $1 in trailing yearly profits.

See our latest analysis for CarMax

How Do I Calculate CarMax's Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for CarMax:

P/E of 16.75 = $85.03 ÷ $5.08 (Based on the trailing twelve months to May 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.

Does CarMax 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. As you can see below, CarMax has a higher P/E than the average company (13.2) in the specialty retail industry.

NYSE:KMX Price Estimation Relative to Market, August 19th 2019

CarMax's P/E tells us that market participants think the company will perform better than its industry peers, going forward. 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. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.

Notably, CarMax grew EPS by a whopping 33% in the last year. And its annual EPS growth rate over 5 years is 17%. With that performance, I would expect it to have an above average P/E ratio.

Don't Forget: The P/E Does Not Account For Debt or Bank Deposits

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. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

So What Does CarMax's Balance Sheet Tell Us?

CarMax has net debt worth a very significant 102% of its market capitalization. If you want to compare its P/E ratio to other companies, you must keep in mind that these debt levels would usually warrant a relatively low P/E.

The Bottom Line On CarMax's P/E Ratio

CarMax's P/E is 16.8 which is about average (17.2) in the US market. While it does have meaningful debt levels, it has also produced strong earnings growth recently. The P/E suggests the market isn't confident that growth will be sustained, though.

Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

Of course you might be able to find a better stock than CarMax. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.