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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We’ll look at PriceSmart, Inc.’s (NASDAQ:PSMT) P/E ratio and reflect on what it tells us about the company’s share price. PriceSmart has a price to earnings ratio of 28, based on the last twelve months. That means that at current prices, buyers pay $28 for every $1 in trailing yearly profits.
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 PriceSmart:
P/E of 28 = $61 ÷ $2.18 (Based on the trailing twelve months to November 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. 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.’
How Growth Rates Impact P/E Ratios
When earnings fall, the ‘E’ decreases, over time. That means even if the current P/E is low, it will increase over time if the share price stays flat. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
PriceSmart shrunk earnings per share by 25% over the last year. And it has shrunk its earnings per share by 3.6% per year over the last five years. This growth rate might warrant a below average P/E ratio.
How Does PriceSmart’s P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. You can see in the image below that the average P/E (13.2) for companies in the consumer retailing industry is lower than PriceSmart’s P/E.
PriceSmart’s P/E tells us that market participants think the company will perform better than its industry peers, going forward. 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.
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. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
PriceSmart’s Balance Sheet
Since PriceSmart holds net cash of US$7.4m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On PriceSmart’s P/E Ratio
PriceSmart’s P/E is 28 which is above average (16.7) in the US market. Falling earnings per share is probably keeping traditional value investors away, but the relatively strong balance sheet will allow the company time to invest in growth. Clearly, the high P/E indicates shareholders think it will!
Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free visual report on analyst forecasts could hold they key to an excellent investment decision.
You might be able to find a better buy than PriceSmart. 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).
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.