This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll look at Pennon Group Plc’s (LON:PNN) P/E ratio and reflect on what it tells us about the company’s share price. Pennon Group has a P/E ratio of 14.23, based on the last twelve months. That means that at current prices, buyers pay £14.23 for every £1 in trailing yearly profits.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Pennon Group:
P/E of 14.23 = £7.27 ÷ £0.51 (Based on the trailing twelve months to March 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. 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 Pennon Group 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. We can see in the image below that the average P/E (15.9) for companies in the water utilities industry is higher than Pennon Group’s P/E.
This suggests that market participants think Pennon Group will underperform other companies in its industry.
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 unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.
Pennon Group’s earnings per share grew by -6.4% in the last twelve months. And earnings per share have improved by 5.7% annually, over the last five years.
Remember: P/E Ratios Don’t Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won’t reflect the advantage of cash, or disadvantage of debt. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
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.
How Does Pennon Group’s Debt Impact Its P/E Ratio?
Pennon Group has net debt worth 57% of its market capitalization. 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 Pennon Group’s P/E Ratio
Pennon Group has a P/E of 14.2. That’s below the average in the GB market, which is 15.8. While the recent EPS growth is a positive, the significant amount of debt on the balance sheet may be contributing to pessimistic market expectations.
Investors have an opportunity when market expectations about a stock are wrong. 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.
But note: Pennon Group 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).
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.