Despite Its High P/E Ratio, Is InvoCare Limited (ASX:IVC) Still Undervalued?

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we'll show how InvoCare Limited's (ASX:IVC) P/E ratio could help you assess the value on offer. Based on the last twelve months, InvoCare's P/E ratio is 24.24. That corresponds to an earnings yield of approximately 4.1%.

View our latest analysis for InvoCare

How Do I Calculate A Price To Earnings Ratio?

The formula for P/E is:

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

Or for InvoCare:

P/E of 24.24 = A$13.560 ÷ A$0.559 (Based on the year to December 2019.)

(Note: the above calculation results may not be precise due to rounding.)

Is A High P/E Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing 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.

How Does InvoCare'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 (16.0) for companies in the consumer services industry is lower than InvoCare's P/E.

Its relatively high P/E ratio indicates that InvoCare shareholders think it will perform better than other companies in its industry classification. Clearly the market expects growth, but it isn't guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

How Growth Rates Impact P/E Ratios

When earnings fall, the 'E' decreases, over time. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. Then, a higher P/E might scare off shareholders, pushing the share price down.

Notably, InvoCare grew EPS by a whopping 47% in the last year. And its annual EPS growth rate over 5 years is 2.3%. So we'd generally expect it to have a relatively high P/E ratio. But earnings per share are down 4.7% per year over the last three years.

Remember: P/E Ratios Don't Consider The Balance Sheet

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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.

So What Does InvoCare's Balance Sheet Tell Us?

InvoCare has net debt worth 21% of its market capitalization. That's enough debt to impact the P/E ratio a little; so keep it in mind if you're comparing it to companies without debt.

The Bottom Line On InvoCare's P/E Ratio

InvoCare trades on a P/E ratio of 24.2, which is above its market average of 16.2. While the company does use modest debt, its recent earnings growth is superb. So to be frank we are not surprised it has a high P/E ratio.

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.

But note: InvoCare may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

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.

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. Thank you for reading.