Read This Before You Buy American Electric Power Company, Inc. (NYSE:AEP) Because Of Its P/E Ratio

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 American Electric Power Company, Inc.'s (NYSE:AEP), to help you decide if the stock is worth further research. Looking at earnings over the last twelve months, American Electric Power Company has a P/E ratio of 21.85. That means that at current prices, buyers pay $21.85 for every $1 in trailing yearly profits.

See our latest analysis for American Electric Power Company

How Do I Calculate American Electric Power Company's Price To Earnings Ratio?

The formula for P/E is:

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

Or for American Electric Power Company:

P/E of 21.85 = $94.35 ÷ $4.32 (Based on the year to September 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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 Does American Electric Power Company's P/E Ratio Compare To Its Peers?

One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. If you look at the image below, you can see American Electric Power Company has a lower P/E than the average (23.8) in the electric utilities industry classification.

American Electric Power Company'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. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.

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. Earnings growth means that in the future the 'E' will be higher. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

American Electric Power Company's earnings per share grew by -8.4% in the last twelve months. And its annual EPS growth rate over 5 years is 3.5%.

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

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

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).

How Does American Electric Power Company's Debt Impact Its P/E Ratio?

Net debt totals 60% of American Electric Power Company's market cap. This is enough debt that you'd have to make some adjustments before using the P/E ratio to compare it to a company with net cash.

The Verdict On American Electric Power Company's P/E Ratio

American Electric Power Company has a P/E of 21.8. That's higher than the average in its market, which is 17.8. With meaningful debt and only modest recent earnings growth, the market is either expecting reliable long-term growth, or a near-term improvement.

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 American Electric Power Company. 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 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.