Today, we’ll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we’ll show how Fortescue Metals Group Limited’s (ASX:FMG) P/E ratio could help you assess the value on offer. Based on the last twelve months, Fortescue Metals Group’s P/E ratio is 3.76. That means that at current prices, buyers pay A$3.76 for every A$1 in trailing yearly profits.
How Do You Calculate Fortescue Metals Group’s P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)
Or for Fortescue Metals Group:
P/E of 3.76 = $6.100 ÷ $1.621 (Based on the year to December 2019.)
(Note: the above calculation uses the share price in the reporting currency, namely USD and the calculation results may not be precise due to rounding.)
Is A High P/E Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn’t a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business’s prospects, relative to stocks with a lower P/E.
How Does Fortescue Metals Group’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 Fortescue Metals Group has a lower P/E than the average (10.0) in the metals and mining industry classification.
This suggests that market participants think Fortescue Metals Group will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. When earnings grow, the ‘E’ increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
Fortescue Metals Group’s 498% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. The sweetener is that the annual five year growth rate of 30% is also impressive. With that kind of growth rate we would generally expect a high P/E ratio.
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. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
Fortescue Metals Group’s Balance Sheet
Fortescue Metals Group has net cash of US$110m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Verdict On Fortescue Metals Group’s P/E Ratio
Fortescue Metals Group trades on a P/E ratio of 3.8, which is below the AU market average of 16.2. It grew its EPS nicely over the last year, and the healthy balance sheet implies there is more potential for growth. The relatively low P/E ratio implies the market is pessimistic.
Investors should be looking to buy stocks that the market is wrong about. 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 Fortescue Metals Group. So you may wish to see this free collection of other companies that have grown earnings strongly.
If you spot an error that warrants correction, please contact the editor at email@example.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.
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