The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at Universal Corporation's (NYSE:UVV) P/E ratio and reflect on what it tells us about the company's share price. What is Universal's P/E ratio? Well, based on the last twelve months it is 14.31. That corresponds to an earnings yield of approximately 7.0%.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Universal:
P/E of 14.31 = $51.05 ÷ $3.57 (Based on the year to September 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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 Universal's P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. You can see in the image below that the average P/E (14.3) for companies in the tobacco industry is roughly the same as Universal's P/E.
Its P/E ratio suggests that Universal shareholders think that in the future it will perform about the same as other companies in its industry classification. So if Universal actually outperforms its peers going forward, that should be a positive for the share price. Checking factors such as director buying and selling. could help you form your own view on if that will happen.
How Growth Rates Impact P/E Ratios
Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means even if the current P/E is low, it will increase over time if the share price stays flat. Then, a higher P/E might scare off shareholders, pushing the share price down.
Universal's earnings per share fell by 26% in the last twelve months. But over the longer term (5 years) earnings per share have increased by 4.6%. And EPS is down 6.0% a year, over the last 3 years. This could justify a low P/E.
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. 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 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 Universal's Debt Impact Its P/E Ratio?
Universal has net debt equal to 39% of its market cap. While it's worth keeping this in mind, it isn't a worry.
The Bottom Line On Universal's P/E Ratio
Universal trades on a P/E ratio of 14.3, which is below the US market average of 18.1. Since it only carries a modest debt load, it's likely the low expectations implied by the P/E ratio arise from the lack of recent earnings growth.
Investors have an opportunity when market expectations about a stock are wrong. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. Although we don't have analyst forecasts you could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.
Of course you might be able to find a better stock than Universal. 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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