Is Automotive Finco Corp.'s (CVE:AFCC) P/E Ratio Really That Good?

This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we'll show how Automotive Finco Corp.'s (CVE:AFCC) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, Automotive Finco has a P/E ratio of 9.75. That means that at current prices, buyers pay CA$9.75 for every CA$1 in trailing yearly profits.

See our latest analysis for Automotive Finco

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for Automotive Finco:

P/E of 9.75 = CA$1.74 ÷ CA$0.18 (Based on the trailing twelve months to June 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.

Does Automotive Finco Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio indicates whether the market has higher or lower expectations of a company. We can see in the image below that the average P/E (11.4) for companies in the diversified financial industry is higher than Automotive Finco's P/E.

This suggests that market participants think Automotive Finco will underperform other companies in its industry.

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. And in that case, the P/E ratio itself will drop rather quickly. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

Automotive Finco's 157% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. And earnings per share have improved by 137% annually, over the last three years. So we'd absolutely expect it to have a relatively high P/E ratio. The market might expect further growth, but it isn't guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

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

Don't forget that the P/E ratio considers market capitalization. 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 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.

Is Debt Impacting Automotive Finco's P/E?

Automotive Finco's net debt is 81% of its market cap. This is a reasonably significant level of debt -- all else being equal you'd expect a much lower P/E than if it had net cash.

The Verdict On Automotive Finco's P/E Ratio

Automotive Finco's P/E is 9.7 which is below average (14.5) in the CA market. While the EPS growth last year was strong, the significant debt levels reduce the number of options available to management. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.

Investors have an opportunity when market expectations about a stock are wrong. 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. 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.

You might be able to find a better buy than Automotive Finco. 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).

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

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. Thank you for reading.