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This article is written for those who want to get better at using 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 22.1. In other words, at today’s prices, investors are paying $22.1 for every $1 in prior year profit.
How Do You Calculate American Electric Power Company’s P/E 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 22.1 = $91.55 ÷ $4.14 (Based on the trailing twelve months to March 2019.)
Is A High Price-to-Earnings Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing 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. 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.
It’s great to see that American Electric Power Company grew EPS by 15% in the last year. And it has bolstered its earnings per share by 3.8% per year over the last five years. So one might expect an above average P/E ratio.
Does American Electric Power Company Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (22.6) for companies in the electric utilities industry is roughly the same as American Electric Power Company’s P/E.
American Electric Power Company’s P/E tells us that market participants think its prospects are roughly in line with 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.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The ‘Price’ in P/E reflects the market capitalization of the company. That means it doesn’t take debt or cash into account. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on 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).
So What Does American Electric Power Company’s Balance Sheet Tell Us?
American Electric Power Company has net debt worth 58% of its market capitalization. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.
The Verdict On American Electric Power Company’s P/E Ratio
American Electric Power Company has a P/E of 22.1. That’s higher than the average in the US market, which is 17.9. It’s good to see the recent earnings growth, although we note the company uses debt already. But if growth falters, the relatively high P/E ratio may prove to be unjustified.
Investors should be looking to buy stocks that the market is wrong about. 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 the key to an excellent investment decision.
Of course you might be able to find a better stock than American Electric Power Company. So you may wish to see this free collection of other companies that have grown earnings strongly.
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.