Is Goodwin plc's (LON:GDWN) High P/E Ratio A Problem For Investors?

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This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll look at Goodwin plc's (LON:GDWN) P/E ratio and reflect on what it tells us about the company's share price. Goodwin has a P/E ratio of 20.72, based on the last twelve months. That means that at current prices, buyers pay £20.72 for every £1 in trailing yearly profits.

Check out our latest analysis for Goodwin

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

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

Or for Goodwin:

P/E of 20.72 = £27.9 ÷ £1.35 (Based on the trailing twelve months to October 2018.)

Is A High P/E Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.

How Growth Rates Impact P/E Ratios

When earnings fall, the 'E' decreases, over time. That means even if the current P/E is low, it will increase over time if the share price stays flat. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.

Goodwin increased earnings per share by a whopping 52% last year. Unfortunately, earnings per share are down 24% a year, over 5 years.

How Does Goodwin's P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. The image below shows that Goodwin has a P/E ratio that is roughly in line with the machinery industry average (19.6).

That indicates that the market expects Goodwin will perform roughly in line with other companies in its industry. If the company has better than average prospects, then the market might be underestimating it. Checking factors such as the tenure of the board and management could help you form your own view on if that will happen.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

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 expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

Goodwin's Balance Sheet

Net debt totals just 5.8% of Goodwin's market cap. It would probably trade on a higher P/E ratio if it had a lot of cash, but I doubt it is having a big impact.

The Bottom Line On Goodwin's P/E Ratio

Goodwin's P/E is 20.7 which is above average (15.7) in the GB market. Its debt levels do not imperil its balance sheet and it has already proven it can grow. So it is not surprising the market is probably extrapolating recent growth well into the future, reflected in the relatively high P/E ratio.

Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. Although we don't have analyst forecasts, shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.

Of course you might be able to find a better stock than Goodwin. So you may wish to see this freecollection of other companies that have grown earnings strongly.

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 editorial-team@simplywallst.com.

Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.