Why Toromont Industries Ltd.'s (TSE:TIH) High P/E Ratio Isn't Necessarily A Bad Thing

October 23, 2019

The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll show how you can use Toromont Industries Ltd.'s (TSE:TIH) P/E ratio to inform your assessment of the investment opportunity. Toromont Industries has a price to earnings ratio of 19.78, based on the last twelve months. That means that at current prices, buyers pay CA$19.78 for every CA$1 in trailing yearly profits.

View our latest analysis for Toromont Industries

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 Toromont Industries:

P/E of 19.78 = CA$65.67 ÷ CA$3.32 (Based on the trailing twelve months to June 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 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 Toromont Industries Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio essentially measures market expectations of a company. As you can see below, Toromont Industries has a higher P/E than the average company (13.3) in the trade distributors industry.

TSX:TIH Price Estimation Relative to Market, October 23rd 2019

That means that the market expects Toromont Industries will outperform other companies in its industry. 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

P/E ratios primarily reflect market expectations around earnings growth rates. 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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Notably, Toromont Industries grew EPS by a whopping 29% in the last year. And it has bolstered its earnings per share by 15% per year over the last five years. So we'd generally expect it to have a relatively high P/E ratio.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. Thus, the metric does not reflect cash or debt held by the company. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.

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.

So What Does Toromont Industries's Balance Sheet Tell Us?

Net debt totals just 9.2% of Toromont Industries's market cap. The market might award it a higher P/E ratio if it had net cash, but its unlikely this low level of net borrowing is having a big impact on the P/E multiple.

The Bottom Line On Toromont Industries's P/E Ratio

Toromont Industries has a P/E of 19.8. That's higher than the average in its market, which is 13.7. 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. 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.

Of course you might be able to find a better stock than Toromont Industries. 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 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. Thank you for reading.