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 Probiotec Limited’s (ASX:PBP) P/E ratio could help you assess the value on offer. What is Probiotec’s P/E ratio? Well, based on the last twelve months it is 24.48. That is equivalent to an earnings yield of about 4.1%.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Probiotec:
P/E of 24.48 = A$1.850 ÷ A$0.076 (Based on the trailing twelve months to December 2019.)
(Note: the above calculation results may not be precise due to rounding.)
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 isn’t necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
Does Probiotec Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. The image below shows that Probiotec has a higher P/E than the average (18.9) P/E for companies in the pharmaceuticals industry.
Probiotec’s P/E tells us that market participants think the company will perform better than its industry peers, going forward. Shareholders are clearly optimistic, but the future is always uncertain. 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
Generally speaking the rate of earnings growth has a profound impact on a company’s P/E multiple. When earnings grow, the ‘E’ increases, over time. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Notably, Probiotec grew EPS by a whopping 26% in the last year. And earnings per share have improved by 12% annually, over the last three years. So we’d generally expect it to have a relatively high P/E ratio.
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. 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).
How Does Probiotec’s Debt Impact Its P/E Ratio?
Probiotec has net debt worth just 2.7% of its market capitalization. It would probably trade on a higher P/E ratio if it had a lot of cash, but I doubt it is having a big impact.
The Bottom Line On Probiotec’s P/E Ratio
Probiotec’s P/E is 24.5 which is above average (15.7) in its market. While the company does use modest debt, its recent earnings growth is very good. So on this analysis it seems reasonable that its P/E ratio is above average.
When the market is wrong about a stock, it gives savvy investors an opportunity. People often underestimate remarkable growth — so investors can make money when fast growth is not fully appreciated. 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.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned. Thank you for reading.