The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how Ariadne Australia Limited's (ASX:ARA) P/E ratio could help you assess the value on offer. Ariadne Australia has a price to earnings ratio of 9.1, based on the last twelve months. That is equivalent to an earnings yield of about 11%.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Ariadne Australia:
P/E of 9.1 = A$0.69 ÷ A$0.076 (Based on the year to June 2018.)
Is A High Price-to-Earnings 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 isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.
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. 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, Ariadne Australia grew EPS by a whopping 44% in the last year. And it has bolstered its earnings per share by 31% 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 Ariadne Australia's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. We can see in the image below that the average P/E (16.7) for companies in the commercial services industry is higher than Ariadne Australia's P/E.
This suggests that market participants think Ariadne Australia will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
Remember: P/E Ratios Don't Consider The Balance Sheet
Don't forget that the P/E ratio considers market capitalization. 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.
How Does Ariadne Australia's Debt Impact Its P/E Ratio?
Ariadne Australia has net cash of AU$21m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Bottom Line On Ariadne Australia's P/E Ratio
Ariadne Australia has a P/E of 9.1. That's below the average in the AU market, which is 15.4. Not only should the net cash position reduce risk, but the recent growth has been impressive. One might conclude that the market is a bit pessimistic, given the low P/E ratio.
When the market is wrong about a stock, it gives savvy investors an opportunity. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. We don't have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than Ariadne Australia. If you want a selection of possible winners, check out this freelist 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 firstname.lastname@example.org.
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Simply Wall St has no position in any of the companies mentioned. This article 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.
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