Should You Be Tempted To Sell FRIWO AG (FRA:CEA) Because Of Its P/E Ratio?

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This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We’ll apply a basic P/E ratio analysis to FRIWO AG’s (FRA:CEA), to help you decide if the stock is worth further research. Looking at earnings over the last twelve months, FRIWO has a P/E ratio of 35.56. That corresponds to an earnings yield of approximately 2.8%.

See our latest analysis for FRIWO

How Do I Calculate A Price To Earnings Ratio?

The formula for P/E is:

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

Or for FRIWO:

P/E of 35.56 = €24.6 ÷ €0.69 (Based on the year 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 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

Probably the most important factor in determining what P/E a company trades on is the earnings growth. If earnings are growing quickly, then the ‘E’ in the equation will increase faster than it would otherwise. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.

FRIWO saw earnings per share decrease by 24% last year. But it has grown its earnings per share by 16% per year over the last five years.

How Does FRIWO’s P/E Ratio Compare To Its Peers?

The P/E ratio indicates whether the market has higher or lower expectations of a company. You can see in the image below that the average P/E (34.5) for companies in the electrical industry is roughly the same as FRIWO’s P/E.

DB:CEA Price Estimation Relative to Market, April 30th 2019
DB:CEA Price Estimation Relative to Market, April 30th 2019

FRIWO’s P/E tells us that market participants think its prospects are roughly in line with its industry. The company could surprise by performing better than average, in the future. Checking factors such as the tenure of the board and management could help you form your own view on if that will happen.

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

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.

So What Does FRIWO’s Balance Sheet Tell Us?

FRIWO has net debt worth just 6.3% of its market capitalization. So it doesn’t have as many options as it would with net cash, but its debt would not have much of an impact on its P/E ratio.

The Verdict On FRIWO’s P/E Ratio

FRIWO trades on a P/E ratio of 35.6, which is above the DE market average of 20.4. With modest debt but no EPS growth in the last year, it’s fair to say the P/E implies some optimism about future earnings, from the market.

Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. Although we don’t have analyst forecasts, shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.

But note: FRIWO 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).

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.