This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we'll show how NVR, Inc.'s (NYSE:NVR) P/E ratio could help you assess the value on offer. What is NVR's P/E ratio? Well, based on the last twelve months it is 16.04. That corresponds to an earnings yield of approximately 6.2%.
How Do You Calculate NVR's P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for NVR:
P/E of 16.04 = $3781.43 ÷ $235.79 (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. 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 NVR 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. The image below shows that NVR has a higher P/E than the average (13.5) P/E for companies in the consumer durables industry.
Its relatively high P/E ratio indicates that NVR 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. 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.
Notably, NVR grew EPS by a whopping 25% in the last year. And its annual EPS growth rate over 5 years is 30%. I'd therefore be a little surprised if its P/E ratio was not relatively high.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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.
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.
So What Does NVR's Balance Sheet Tell Us?
The extra options and safety that comes with NVR's US$470m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Verdict On NVR's P/E Ratio
NVR has a P/E of 16.0. That's below the average in the US market, which is 18.9. The net cash position gives plenty of options to the business, and the recent improvement in EPS is good to see. The relatively low P/E ratio implies the market is pessimistic.
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.
You might be able to find a better buy than NVR. 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).
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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