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 PWR Holdings Limited’s (ASX:PWH) P/E ratio could help you assess the value on offer. Based on the last twelve months, PWR Holdings’s P/E ratio is 29.8. That means that at current prices, buyers pay A$29.8 for every A$1 in trailing yearly profits.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for PWR Holdings:
P/E of 29.8 = A$3.6 ÷ A$0.12 (Based on the year to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each A$1 of company earnings. 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.
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. When earnings grow, the ‘E’ increases, over time. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.
PWR Holdings increased earnings per share by a whopping 27% last year. And it has bolstered its earnings per share by 8.3% per year over the last five years. I’d therefore be a little surprised if its P/E ratio was not relatively high.
How Does PWR Holdings’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. As you can see below, PWR Holdings has a higher P/E than the average company (14.5) in the auto components industry.
PWR Holdings’s P/E tells us that market participants think the company will perform better than its industry peers, going forward. The market is optimistic about the future, but that doesn’t guarantee future growth. So further research is always essential. I often monitor director buying and selling.
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. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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.
PWR Holdings’s Balance Sheet
PWR Holdings has net cash of AU$2.8m. 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 PWR Holdings’s P/E Ratio
PWR Holdings’s P/E is 29.8 which is above average (16.1) in the AU market. Its strong balance sheet gives the company plenty of resources for extra growth, and it has already proven it can grow. So it does not seem strange that the P/E is above average.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
You might be able to find a better buy than PWR Holdings. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
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.