Is Gear Energy Ltd.'s (TSE:GXE) High P/E Ratio A Problem For Investors?

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Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll apply a basic P/E ratio analysis to Gear Energy Ltd.'s (TSE:GXE), to help you decide if the stock is worth further research. Gear Energy has a P/E ratio of 41.19, based on the last twelve months. That corresponds to an earnings yield of approximately 2.4%.

See our latest analysis for Gear Energy

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 Gear Energy:

P/E of 41.19 = CA$0.51 ÷ CA$0.012 (Based on the year to March 2019.)

Is A High P/E Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.

Does Gear Energy 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. As you can see below, Gear Energy has a much higher P/E than the average company (13.1) in the oil and gas industry.

That means that the market expects Gear Energy will outperform other companies in its industry.

How Growth Rates Impact P/E Ratios

Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. And in that case, the P/E ratio itself will drop rather quickly. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

Gear Energy's earnings per share fell by 19% in the last twelve months. And it has shrunk its earnings per share by 31% per year over the last five years. This could justify a pessimistic P/E.

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. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.

So What Does Gear Energy's Balance Sheet Tell Us?

Gear Energy's net debt is 82% of its market cap. This is enough debt that you'd have to make some adjustments before using the P/E ratio to compare it to a company with net cash.

The Verdict On Gear Energy's P/E Ratio

Gear Energy trades on a P/E ratio of 41.2, which is above its market average of 15. With relatively high debt, and no earnings per share growth over twelve months, it's safe to say the market believes the company will improve its earnings growth in the future.

Investors should be looking to buy stocks that the market is wrong about. 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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

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.

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.