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

This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll look at Gear Energy Ltd.’s (TSE:GXE) P/E ratio and reflect on what it tells us about the company’s share price. Based on the last twelve months, Gear Energy’s P/E ratio is 22.61. That is equivalent to an earnings yield of about 4.4%.

See our latest analysis for Gear Energy

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Gear Energy:

P/E of 22.61 = CA$0.57 ÷ CA$0.025 (Based on the trailing twelve months to December 2018.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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

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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Gear Energy saw earnings per share decrease by 52% last year. But EPS is up 11% over the last 5 years.

How Does Gear Energy’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 Gear Energy has a higher P/E than the average (15.5) P/E for companies in the oil and gas industry.

TSX:GXE Price Estimation Relative to Market, March 18th 2019
TSX:GXE Price Estimation Relative to Market, March 18th 2019

That means that the market expects Gear Energy will outperform other companies in its industry. The market is optimistic about the future, but that doesn’t guarantee future growth. So investors should delve deeper. I like to check if company insiders have been buying or selling.

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

The ‘Price’ in P/E reflects the market capitalization of the company. That means it doesn’t take debt or cash into account. 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 Gear Energy’s Debt Impact Its P/E Ratio?

Gear Energy’s net debt is 72% of its market cap. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.

The Bottom Line On Gear Energy’s P/E Ratio

Gear Energy’s P/E is 22.6 which is above average (14.8) in the CA market. With meaningful debt and a lack of recent earnings growth, the market has high expectations that the business will earn more in the future.

Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

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.