Is AMA Group Limited’s (ASX:AMA) High P/E Ratio A Problem For Investors?

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This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll show how you can use AMA Group Limited’s (ASX:AMA) P/E ratio to inform your assessment of the investment opportunity. Looking at earnings over the last twelve months, AMA Group has a P/E ratio of 38.22. That corresponds to an earnings yield of approximately 2.6%.

See our latest analysis for AMA Group

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 AMA Group:

P/E of 38.22 = A$1.26 ÷ A$0.033 (Based on the year to December 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. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the ‘E’ will be higher. 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.

AMA Group increased earnings per share by 6.5% last year. And earnings per share have improved by 12% annually, over the last five years.

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

The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that AMA Group has a higher P/E than the average (22.3) P/E for companies in the commercial services industry.

ASX:AMA Price Estimation Relative to Market, May 29th 2019
ASX:AMA Price Estimation Relative to Market, May 29th 2019

AMA Group’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.

Remember: P/E Ratios Don’t Consider The Balance Sheet

It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn’t take debt or cash into account. 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).

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 AMA Group’s Debt Impact Its P/E Ratio?

Net debt totals 12% of AMA Group’s market cap. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.

The Verdict On AMA Group’s P/E Ratio

AMA Group’s P/E is 38.2 which is above average (16.2) in the AU market. Given the debt is only modest, and earnings are already moving in the right direction, it’s not surprising that the market expects continued improvement.

Investors should be looking to buy stocks that the market is wrong about. 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.

But note: AMA 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 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.