This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Northland Power Inc.’s (TSE:NPI) P/E ratio could help you assess the value on offer. Based on the last twelve months, Northland Power’s P/E ratio is 13.77. That is equivalent to an earnings yield of about 7.3%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Northland Power:
P/E of 13.77 = CA$21.06 ÷ CA$1.53 (Based on the trailing twelve months to September 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each CA$1 of company earnings. 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
Earnings growth rates have a big influence on P/E ratios. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. 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.
Northland Power had pretty flat EPS growth in the last year. But over the longer term (5 years) earnings per share have increased by 31%.
How Does Northland Power’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Northland Power has a P/E ratio that is roughly in line with the renewable energy industry average (14.2).
Its P/E ratio suggests that Northland Power shareholders think that in the future it will perform about the same as other companies in its industry classification. So if Northland Power actually outperforms its peers going forward, that should be a positive for the share price. I inform my view byby checking management tenure and remuneration, among other things.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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).
How Does Northland Power’s Debt Impact Its P/E Ratio?
Northland Power’s net debt is considerable, at 191% of its market cap. If you want to compare its P/E ratio to other companies, you must keep in mind that these debt levels would usually warrant a relatively low P/E.
The Verdict On Northland Power’s P/E Ratio
Northland Power trades on a P/E ratio of 13.8, which is fairly close to the CA market average of 13. With meaningful debt, and no earnings per share growth last year, even an average P/E indicates that the market a significant improvement from the business.
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 visual report on analyst forecasts could hold they key to an excellent investment decision.
You might be able to find a better buy than Northland Power. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
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.