Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how Cavco Industries, Inc.'s (NASDAQ:CVCO) P/E ratio could help you assess the value on offer. Cavco Industries has a P/E ratio of 23.15, based on the last twelve months. That means that at current prices, buyers pay $23.15 for every $1 in trailing yearly profits.
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 Cavco Industries:
P/E of 23.15 = $192.00 ÷ $8.30 (Based on the trailing twelve months to September 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
How Does Cavco Industries's P/E Ratio Compare To Its Peers?
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 (13.6) for companies in the consumer durables industry is lower than Cavco Industries's P/E.
Its relatively high P/E ratio indicates that Cavco Industries shareholders think it will perform better than other companies in its industry classification. Shareholders are clearly optimistic, but the future is always uncertain. 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 even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Cavco Industries shrunk earnings per share by 4.7% last year. But over the longer term (5 years) earnings per share have increased by 28%.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
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 Cavco Industries's Balance Sheet Tell Us?
With net cash of US$189m, Cavco Industries has a very strong balance sheet, which may be important for its business. Having said that, at 11% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Verdict On Cavco Industries's P/E Ratio
Cavco Industries trades on a P/E ratio of 23.1, which is above its market average of 18.1. The recent drop in earnings per share would make some investors cautious, but the net cash position means the company has time to improve: and the high P/E suggests the market thinks it will.
Investors have an opportunity when market expectations about a stock are wrong. 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 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 Cavco Industries. So you may wish to see this free collection of other companies that have grown earnings strongly.
If you spot an error that warrants correction, please contact the editor at email@example.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.
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