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 Fairfax Financial Holdings Limited's (TSE:FFH) P/E ratio to inform your assessment of the investment opportunity. Fairfax Financial Holdings has a P/E ratio of 15.64, based on the last twelve months. That is equivalent to an earnings yield of about 6.4%.
How Do I Calculate Fairfax Financial Holdings's Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for Fairfax Financial Holdings:
P/E of 15.64 = CA$468.03 (Note: this is the share price in the reporting currency, namely, USD ) ÷ CA$29.93 (Based on the trailing twelve months to September 2019.)
Is A High Price-to-Earnings Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. 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 Fairfax Financial Holdings Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. The image below shows that Fairfax Financial Holdings has a higher P/E than the average (14.2) P/E for companies in the insurance industry.
Fairfax Financial Holdings's P/E tells us that market participants think the company will perform better than its industry peers, going forward. 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. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Fairfax Financial Holdings shrunk earnings per share by 51% over the last year. But EPS is up 40% over the last 3 years. And over the longer term (5 years) earnings per share have decreased 16% annually. This growth rate might warrant a below average P/E ratio.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
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. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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.
How Does Fairfax Financial Holdings's Debt Impact Its P/E Ratio?
With net cash of US$3.4b, Fairfax Financial Holdings has a very strong balance sheet, which may be important for its business. Having said that, at 27% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On Fairfax Financial Holdings's P/E Ratio
Fairfax Financial Holdings trades on a P/E ratio of 15.6, which is fairly close to the CA market average of 15.9. While the absence of growth in the last year is probably causing a degree of pessimism, the healthy balance sheet means the company retains potential for future growth. So it's not surprising to see it trade on a P/E roughly in line with the market.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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.
But note: Fairfax Financial Holdings 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).
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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