Here’s How P/E Ratios Can Help Us Understand Berkshire Hathaway Inc. (NYSE:BRK.A)

The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We’ll look at Berkshire Hathaway Inc.’s (NYSE:BRK.A) P/E ratio and reflect on what it tells us about the company’s share price. Based on the last twelve months, Berkshire Hathaway’s P/E ratio is 7.5. That corresponds to an earnings yield of approximately 13%.

Check out our latest analysis for Berkshire Hathaway

How Do I Calculate Berkshire Hathaway’s Price To Earnings Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Berkshire Hathaway:

P/E of 7.5 = $282640 ÷ $37677.52 (Based on the year to September 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

Probably the most important factor in determining what P/E a company trades on is the earnings growth. When earnings grow, the ‘E’ increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Notably, Berkshire Hathaway grew EPS by a whopping 232% in the last year. And earnings per share have improved by 20% annually, over the last five years. With that performance, I would expect it to have an above average P/E ratio.

How Does Berkshire Hathaway’s P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. The image below shows that Berkshire Hathaway has a lower P/E than the average (23) P/E for companies in the diversified financial industry.

NYSE:BRK.A PE PEG Gauge December 26th 18
NYSE:BRK.A PE PEG Gauge December 26th 18

This suggests that market participants think Berkshire Hathaway will underperform other companies in its industry. Many investors like to buy stocks when the market is pessimistic about their prospects. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

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

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.

Is Debt Impacting Berkshire Hathaway’s P/E?

Berkshire Hathaway has net cash of US$2.1b. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.

The Bottom Line On Berkshire Hathaway’s P/E Ratio

Berkshire Hathaway has a P/E of 7.5. That’s below the average in the US market, which is 15.6. The net cash position gives plenty of options to the business, and the recent improvement in EPS is good to see. The relatively low P/E ratio implies the market is pessimistic.

Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free report on the analyst consensus forecasts could help you make a master move on this stock.

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

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 editorial-team@simplywallst.com.