This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we’ll show how FRoSTA Aktiengesellschaft’s (FRA:NLM) P/E ratio could help you assess the value on offer. FRoSTA has a price to earnings ratio of 21.14, based on the last twelve months. That is equivalent to an earnings yield of about 4.7%.
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 FRoSTA:
P/E of 21.14 = €62 ÷ €2.93 (Based on the trailing twelve months to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each €1 of company earnings. All else being equal, it’s better to pay a low price — but as Warren Buffett said, ‘It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.’
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
FRoSTA saw earnings per share decrease by 14% last year. But it has grown its earnings per share by 10% per year over the last five years.
How Does FRoSTA’s P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. We can see in the image below that the average P/E (26.9) for companies in the food industry is higher than FRoSTA’s P/E.
FRoSTA’s P/E tells us that market participants think it will not fare as well as its peers in the same industry. Many investors like to buy stocks when the market is pessimistic about their prospects. You should delve deeper. I like to check if company insiders have been buying or selling.
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. That means it doesn’t take debt or cash into account. 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 FRoSTA’s Debt Impact Its P/E Ratio?
Net debt totals just 6.9% of FRoSTA’s market cap. 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 FRoSTA’s P/E Ratio
FRoSTA trades on a P/E ratio of 21.1, which is above the DE market average of 18.4. With a bit of debt, but a lack of recent growth, it’s safe to say the market is expecting improved profit performance from the company, in the next few years.
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 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 be able to find a better stock than FRoSTA. So you may wish to see this free collection of other companies that have grown earnings strongly.
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 firstname.lastname@example.org. 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.