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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 The Southern Company’s (NYSE:SO) P/E ratio and reflect on what it tells us about the company’s share price. What is Southern’s P/E ratio? Well, based on the last twelve months it is 16.95. That means that at current prices, buyers pay $16.95 for every $1 in trailing yearly profits.
How Do I Calculate Southern’s Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Southern:
P/E of 16.95 = $55.66 ÷ $3.28 (Based on the trailing twelve months to March 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
Does Southern Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio indicates whether the market has higher or lower expectations of a company. If you look at the image below, you can see Southern has a lower P/E than the average (22.7) in the electric utilities industry classification.
Its relatively low P/E ratio indicates that Southern shareholders think it will struggle to do as well as other companies in its industry classification.
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. If earnings are growing quickly, then the ‘E’ in the equation will increase faster than it would otherwise. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.
Southern’s earnings made like a rocket, taking off 194% last year. Having said that, if we look back three years, EPS growth has averaged a comparatively less impressive 8.4%.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don’t forget that the P/E ratio considers market capitalization. That means it doesn’t take debt or cash into account. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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).
Southern’s Balance Sheet
Southern’s net debt is 74% of its market cap. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.
The Bottom Line On Southern’s P/E Ratio
Southern has a P/E of 17. That’s around the same as the average in the US market, which is 18. While it does have meaningful debt levels, it has also produced strong earnings growth recently. The P/E suggests that the market is not convinced EPS will continue to improve strongly.
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 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 Southern. 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.