Should You Be Tempted To Sell ALS Limited (ASX:ALQ) Because Of Its P/E Ratio?

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We’ll show how you can use ALS Limited’s (ASX:ALQ) P/E ratio to inform your assessment of the investment opportunity. ALS has a P/E ratio of 23.32, based on the last twelve months. That is equivalent to an earnings yield of about 4.3%.

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How Do You Calculate A P/E Ratio?

The formula for P/E is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for ALS:

P/E of 23.32 = A$7.09 ÷ A$0.30 (Based on the year to September 2018.)

Is A High P/E Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each A$1 the company has earned over the last year. All else being equal, it’s better to pay a low price — but as Warren Buffett said, ‘It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.’

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. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. 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.

It’s nice to see that ALS grew EPS by a stonking 219% in the last year. And earnings per share have improved by 95% annually, over the last three years. With that performance, I would expect it to have an above average P/E ratio. But earnings per share are down 2.9% per year over the last five years.

How Does ALS’s P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. As you can see below ALS has a P/E ratio that is fairly close for the average for the professional services industry, which is 21.9.

ASX:ALQ PE PEG Gauge January 18th 19
ASX:ALQ PE PEG Gauge January 18th 19

Its P/E ratio suggests that ALS shareholders think that in the future it will perform about the same as other companies in its industry classification. If the company has better than average prospects, then the market might be underestimating it. I inform my view byby checking management tenure and remuneration, among other things.

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.

ALS’s Balance Sheet

Net debt totals 17% of ALS’s market cap. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.

The Verdict On ALS’s P/E Ratio

ALS trades on a P/E ratio of 23.3, which is above the AU market average of 15.1. The company is not overly constrained by its modest debt levels, and it is growing earnings per share. Therefore it seems reasonable that the market would have relatively high expectations of the company

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 visual report on analyst forecasts could hold they key to an excellent investment decision.

You might be able to find a better buy than ALS. 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).

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.