Today, we’ll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we’ll show how Builders FirstSource, Inc.’s (NASDAQ:BLDR) P/E ratio could help you assess the value on offer. Builders FirstSource has a P/E ratio of 7.87, based on the last twelve months. That corresponds to an earnings yield of approximately 13%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Builders FirstSource:
P/E of 7.87 = $14.09 ÷ $1.79 (Based on the year to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each $1 the company has earned over the last year. That isn’t necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. When earnings grow, the ‘E’ increases, over time. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Builders FirstSource’s earnings made like a rocket, taking off 420% last year.
How Does Builders FirstSource’s P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. We can see in the image below that the average P/E (19.1) for companies in the building industry is higher than Builders FirstSource’s P/E.
Its relatively low P/E ratio indicates that Builders FirstSource shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Builders FirstSource, it’s quite possible it could surprise on the upside. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
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.
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).
Is Debt Impacting Builders FirstSource’s P/E?
Net debt totals 95% of Builders FirstSource’s market cap. This is enough debt that you’d have to make some adjustments before using the P/E ratio to compare it to a company with net cash.
The Verdict On Builders FirstSource’s P/E Ratio
Builders FirstSource’s P/E is 7.9 which is below average (18.2) in the US market. While the EPS growth last year was strong, the significant debt levels reduce the number of options available to management. The low P/E ratio suggests current market expectations are muted, implying these levels of growth will not continue.
Investors have an opportunity when market expectations about a stock are wrong. As value investor Benjamin Graham famously said, ‘In the short run, the market is a voting machine but in the long run, it is a weighing machine.’ 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 Builders FirstSource. 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.