Read This Before You Buy AGCO Corporation (NYSE:AGCO) Because Of Its P/E Ratio

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 AGCO Corporation's (NYSE:AGCO) P/E ratio to inform your assessment of the investment opportunity. AGCO has a price to earnings ratio of 18.21, based on the last twelve months. That corresponds to an earnings yield of approximately 5.5%.

See our latest analysis for AGCO

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 AGCO:

P/E of 18.21 = $65.97 ÷ $3.62 (Based on the year to December 2018.)

Is A High P/E Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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.

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. 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.

AGCO increased earnings per share by a whopping 55% last year. And it has improved its earnings per share by 8.6% per year over the last three years. So we'd generally expect it to have a relatively high P/E ratio. Unfortunately, earnings per share are down 18% a year, over 5 years.

How Does AGCO's P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. If you look at the image below, you can see AGCO has a lower P/E than the average (20.5) in the machinery industry classification.

AGCO's P/E tells us that market participants think it will not fare as well as its peers in the same industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or selling.

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

Don't forget that the P/E ratio considers market capitalization. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining cash).

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 AGCO's Debt Impact Its P/E Ratio?

AGCO has net debt worth 22% of its market capitalization. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.

The Bottom Line On AGCO's P/E Ratio

AGCO has a P/E of 18.2. That's around the same as the average in the US market, which is 17.4. With only modest debt levels, and strong earnings growth, the market seems to doubt that the growth can be maintained. Because analysts are predicting more growth in the future, one might have expected to see a higher P/E ratio. You can taker closer look at the fundamentals, here.

Investors have an opportunity when market expectations about a stock are wrong. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this freevisual report on analyst forecasts could hold the key to an excellent investment decision.

Of course you might be able to find a better stock than AGCO. So you may wish to see this freecollection of other companies that have grown earnings strongly.

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.