This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll apply a basic P/E ratio analysis to Southwest Airlines Co.’s (NYSE:LUV), to help you decide if the stock is worth further research. Based on the last twelve months, Southwest Airlines’s P/E ratio is 12.27. That is equivalent to an earnings yield of about 8.1%.
How Do I Calculate Southwest Airlines’s Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Southwest Airlines:
P/E of 12.27 = $52.79 ÷ $4.3 (Based on the trailing twelve months 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. 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
Earnings growth rates have a big influence on P/E ratios. If earnings are growing quickly, then the ‘E’ in the equation will increase faster than it would otherwise. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
Southwest Airlines saw earnings per share decrease by 23% last year. But it has grown its earnings per share by 32% per year over the last five years.
How Does Southwest Airlines’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (11.7) for companies in the airlines industry is roughly the same as Southwest Airlines’s P/E.
That indicates that the market expects Southwest Airlines will perform roughly in line with other companies in its industry. If the company has better than average prospects, then the market might be underestimating it. Checking factors such as the tenure of the board and management could help you form your own view on if that will happen.
Remember: P/E Ratios Don’t Consider The Balance Sheet
The ‘Price’ in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
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 Southwest Airlines’s P/E?
The extra options and safety that comes with Southwest Airlines’s US$298m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Verdict On Southwest Airlines’s P/E Ratio
Southwest Airlines’s P/E is 12.3 which is below average (18.3) in the US market. Falling earnings per share are likely to be keeping potential buyers away, the relatively strong balance sheet will allow the company time to invest in growth. If it achieves that, then there’s real potential that the low P/E could eventually indicate undervaluation.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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 Southwest Airlines. 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).
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 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.