The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We’ll look at McPherson’s Limited’s (ASX:MCP) P/E ratio and reflect on what it tells us about the company’s share price. Looking at earnings over the last twelve months, McPherson’s has a P/E ratio of 10.36. In other words, at today’s prices, investors are paying A$10.36 for every A$1 in prior year profit.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for McPherson’s:
P/E of 10.36 = A$1.07 ÷ A$0.10 (Based on the trailing twelve months to December 2018.)
Is A High Price-to-Earnings Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing 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. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
It’s nice to see that McPherson’s grew EPS by a stonking 38% in the last year. And it has improved its earnings per share by 1.4% per year over the last three years. I’d therefore be a little surprised if its P/E ratio was not relatively high.
Does McPherson’s Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that McPherson’s has a P/E ratio that is roughly in line with the consumer durables industry average (10.3).
McPherson’s’s P/E tells us that market participants think its prospects are roughly in line with its industry. If the company has better than average prospects, then the market might be underestimating it. Checking factors such as the tenure of the board and management could help you form your own view on if that will happen.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
Don’t forget that the P/E ratio considers market capitalization. So it won’t reflect the advantage of cash, or disadvantage of debt. 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 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.
Is Debt Impacting McPherson’s’s P/E?
McPherson’s’s net debt is 17% of its 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 Bottom Line On McPherson’s’s P/E Ratio
McPherson’s has a P/E of 10.4. That’s below the average in the AU market, which is 16.4. The EPS growth last year was strong, and debt levels are quite reasonable. The low P/E ratio suggests current market expectations are muted, implying these levels of growth will not continue. Because analysts are predicting more growth in the future, one might have expected to see a higher P/E ratio. You can taker closer look at the fundamentals, here.
When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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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.