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 New Hope Corporation Limited’s (ASX:NHC) P/E ratio could help you assess the value on offer. New Hope has a price to earnings ratio of 18.96, based on the last twelve months. That is equivalent to an earnings yield of about 5.3%.
View our latest analysis for New Hope
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for New Hope:
P/E of 18.96 = A$3.41 ÷ A$0.18 (Based on the year to July 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 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
P/E ratios primarily reflect market expectations around earnings growth rates. When earnings grow, the ‘E’ increases, over time. 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.
New Hope’s earnings per share grew by -6.3% in the last twelve months. And its annual EPS growth rate over 5 years is 37%.
How Does New Hope’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (18) for companies in the oil and gas industry is roughly the same as New Hope’s P/E.
New Hope’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. I inform my view byby checking management tenure and remuneration, among other things.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
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. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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.
New Hope’s Balance Sheet
Since New Hope holds net cash of AU$470m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On New Hope’s P/E Ratio
New Hope has a P/E of 19. That’s higher than the average in the AU market, which is 14.5. Earnings improved over the last year. Also positive, the relatively strong balance sheet will allow for investment in growth — and the P/E indicates shareholders that will happen!
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 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.
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.