The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We’ll apply a basic P/E ratio analysis to Stepan Company’s (NYSE:SCL), to help you decide if the stock is worth further research. What is Stepan’s P/E ratio? Well, based on the last twelve months it is 21.81. That means that at current prices, buyers pay $21.81 for every $1 in trailing yearly profits.
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 Stepan:
P/E of 21.81 = $97.10 ÷ $4.45 (Based on the trailing twelve months to June 2019.)
Is A High P/E 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 Stepan 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. You can see in the image below that the average P/E (20.2) for companies in the chemicals industry is lower than Stepan’s P/E.
Its relatively high P/E ratio indicates that Stepan 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
Earnings growth rates have a big influence on P/E ratios. 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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Stepan’s earnings per share grew by -5.4% in the last twelve months. And it has bolstered its earnings per share by 8.2% per year over the last five years.
Remember: P/E Ratios Don’t Consider The Balance Sheet
Don’t forget that the P/E ratio considers market capitalization. That means it doesn’t take debt or cash into account. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
How Does Stepan’s Debt Impact Its P/E Ratio?
The extra options and safety that comes with Stepan’s US$43m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Bottom Line On Stepan’s P/E Ratio
Stepan trades on a P/E ratio of 21.8, which is above its market average of 18.2. Recent earnings growth wasn’t bad. Also positive, the relatively strong balance sheet will allow for investment in growth — and the P/E indicates shareholders that will happen!
Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth — so investors can make money when fast growth is not fully appreciated. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
You might be able to find a better buy than Stepan. 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).
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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. Thank you for reading.