This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We’ll show how you can use Leon’s Furniture Limited’s (TSE:LNF) P/E ratio to inform your assessment of the investment opportunity. Leon’s Furniture has a P/E ratio of 10.84, based on the last twelve months. In other words, at today’s prices, investors are paying CA$10.84 for every CA$1 in prior year profit.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Leon’s Furniture:
P/E of 10.84 = CA$15.25 ÷ CA$1.41 (Based on the trailing twelve months to September 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 CA$1 the company has earned over the last year. 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
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.
Leon’s Furniture’s earnings per share grew by -2.4% in the last twelve months. And its annual EPS growth rate over 5 years is 9.7%.
How Does Leon’s Furniture’s P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. We can see in the image below that the average P/E (11.8) for companies in the specialty retail industry is higher than Leon’s Furniture’s P/E.
This suggests that market participants think Leon’s Furniture 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.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don’t forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining cash).
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
Leon’s Furniture’s Balance Sheet
Leon’s Furniture has net debt worth just 8.0% of its market capitalization. The market might award it a higher P/E ratio if it had net cash, but its unlikely this low level of net borrowing is having a big impact on the P/E multiple.
The Verdict On Leon’s Furniture’s P/E Ratio
Leon’s Furniture has a P/E of 10.8. That’s below the average in the CA market, which is 12.9. The company hasn’t stretched its balance sheet, and earnings are improving. If you believe growth will continue – or even increase – then the low P/E may signify opportunity.
Investors should be looking to buy stocks that the market is wrong about. 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 visual report on analyst forecasts could hold they key to an excellent investment decision.
But note: Leon’s Furniture may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio 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 firstname.lastname@example.org.