Here's How P/E Ratios Can Help Us Understand Lear Corporation (NYSE:LEA)

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll show how you can use Lear Corporation's (NYSE:LEA) P/E ratio to inform your assessment of the investment opportunity. What is Lear's P/E ratio? Well, based on the last twelve months it is 8.84. That means that at current prices, buyers pay $8.84 for every $1 in trailing yearly profits.

View our latest analysis for Lear

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 Lear:

P/E of 8.84 = USD113.06 ÷ USD12.80 (Based on the year to December 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 is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.

Does Lear 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 Lear has a lower P/E than the average (16.3) P/E for companies in the auto components industry.

This suggests that market participants think Lear will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.

How Growth Rates Impact P/E Ratios

When earnings fall, the 'E' decreases, over time. 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.

Lear'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 8.8%. And it has shrunk its earnings per share by 1.7% per year over the last three years. This might lead to low expectations.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn't take debt or cash into account. 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.

So What Does Lear's Balance Sheet Tell Us?

Lear's net debt is 12% of its market cap. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.

The Verdict On Lear's P/E Ratio

Lear trades on a P/E ratio of 8.8, which is below the US market average of 17.7. With only modest debt, it's likely the lack of EPS growth at least partially explains the pessimism implied by the P/E ratio.

When the market is wrong about a stock, it gives savvy investors an opportunity. 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 report on the analyst consensus forecasts could help you make a master move on this stock.

But note: Lear 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 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.

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