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 Cummins Inc.’s (NYSE:CMI) P/E ratio to inform your assessment of the investment opportunity. Cummins has a P/E ratio of 11.84, based on the last twelve months. That corresponds to an earnings yield of approximately 8.4%.
How Do You Calculate Cummins’s P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Cummins:
P/E of 11.84 = $156.27 ÷ $13.2 (Based on the trailing twelve months to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. 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. 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.
Cummins increased earnings per share by a whopping 120% last year. And its annual EPS growth rate over 3 years is 6.1%. With that performance, I would expect it to have an above average P/E ratio.
How Does Cummins’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. We can see in the image below that the average P/E (20.3) for companies in the machinery industry is higher than Cummins’s P/E.
Its relatively low P/E ratio indicates that Cummins shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Cummins, it’s quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
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. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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.
Cummins’s Balance Sheet
Net debt totals just 3.9% of Cummins’s market cap. So it doesn’t have as many options as it would with net cash, but its debt would not have much of an impact on its P/E ratio.
The Verdict On Cummins’s P/E Ratio
Cummins has a P/E of 11.8. That’s below the average in the US market, which is 17.3. The EPS growth last year was strong, and debt levels are quite reasonable. If it continues to grow, then the current low P/E may prove to be unjustified. 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.
When the market is wrong about a stock, it gives savvy investors an opportunity. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.