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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Morgan Sindall Group plc’s (LON:MGNS) P/E ratio could help you assess the value on offer. Morgan Sindall Group has a price to earnings ratio of 8.57, based on the last twelve months. That is equivalent to an earnings yield of about 12%.
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 Morgan Sindall Group:
P/E of 8.57 = £12.84 ÷ £1.5 (Based on the trailing twelve months to December 2018.)
Is A High P/E 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. When earnings grow, the ‘E’ increases, over time. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
It’s nice to see that Morgan Sindall Group grew EPS by a stonking 26% in the last year. And its annual EPS growth rate over 5 years is 33%. I’d therefore be a little surprised if its P/E ratio was not relatively high.
How Does Morgan Sindall Group’s P/E Ratio Compare To Its Peers?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. If you look at the image below, you can see Morgan Sindall Group has a lower P/E than the average (9.6) in the construction industry classification.
Its relatively low P/E ratio indicates that Morgan Sindall Group shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Morgan Sindall Group, it’s quite possible it could surprise on the upside. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and 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. 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.
While growth expenditure doesn’t always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
Is Debt Impacting Morgan Sindall Group’s P/E?
With net cash of UK£160m, Morgan Sindall Group has a very strong balance sheet, which may be important for its business. Having said that, at 28% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Verdict On Morgan Sindall Group’s P/E Ratio
Morgan Sindall Group has a P/E of 8.6. That’s below the average in the GB market, which is 16.1. Not only should the net cash position reduce risk, but the recent growth has been impressive. The below average P/E ratio suggests that market participants don’t believe the strong growth will continue.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
But note: Morgan Sindall Group 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 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.