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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 Lechwerke AG’s (FRA:LEC) P/E ratio could help you assess the value on offer. Lechwerke has a P/E ratio of 32.99, based on the last twelve months. That means that at current prices, buyers pay €32.99 for every €1 in trailing yearly profits.
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 Lechwerke:
P/E of 32.99 = €95 ÷ €2.88 (Based on the year to June 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 €1 the company has earned over the last year. 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. Earnings growth means that in the future the ‘E’ will be higher. That means unless the share price increases, the P/E will reduce in a few years. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Lechwerke increased earnings per share by 9.5% last year.
How Does Lechwerke’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (12.1) for companies in the electric utilities industry is lower than Lechwerke’s P/E.
Its relatively high P/E ratio indicates that Lechwerke shareholders think it will perform better than other companies in its industry classification. Shareholders are clearly optimistic, but the future is always uncertain. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
Remember: P/E Ratios Don’t Consider The Balance Sheet
Don’t forget that the P/E ratio considers market capitalization. That means it doesn’t take debt or cash into account. 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).
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.
Lechwerke’s Balance Sheet
Since Lechwerke holds net cash of €1.7m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Lechwerke’s P/E Ratio
Lechwerke has a P/E of 33. That’s higher than the average in the DE market, which is 18.3. Recent earnings growth wasn’t bad. And the healthy balance sheet means the company can sustain growth while the P/E suggests shareholders think it will.
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. We don’t have analyst forecasts, but you could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.
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 email@example.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.