The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We’ll look at Hiscox Ltd’s (LON:HSX) P/E ratio and reflect on what it tells us about the company’s share price. Based on the last twelve months, Hiscox’s P/E ratio is 36.78. That is equivalent to an earnings yield of about 2.7%.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for Hiscox:
P/E of 36.78 = £16.23 (Note: this is the share price in the reporting currency, namely, USD ) ÷ £0.44 (Based on the trailing twelve months to June 2019.)
Is A High P/E Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. 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.
Does Hiscox Have A Relatively High Or Low P/E For Its Industry?
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 (13.4) for companies in the insurance industry is lower than Hiscox’s P/E.
Its relatively high P/E ratio indicates that Hiscox shareholders think it will perform better than other companies in its industry classification.
How Growth Rates Impact P/E Ratios
Companies that shrink earnings per share quickly will rapidly decrease the ‘E’ in the equation. That means even if the current P/E is low, it will increase over time if the share price stays flat. Then, a higher P/E might scare off shareholders, pushing the share price down.
In the last year, Hiscox grew EPS like Taylor Swift grew her fan base back in 2010; the 113% gain was both fast and well deserved. Unfortunately, earnings per share are down 18% a year, over 5 years. Shareholders have some reason to be optimistic, but the future is always uncertain. So investors 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
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. 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.
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 Hiscox’s P/E?
Since Hiscox holds net cash of US$201m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Hiscox’s P/E Ratio
Hiscox’s P/E is 36.8 which is above average (16.9) in its market. Its net cash position is the cherry on top of its superb EPS growth. So based on this analysis we’d expect Hiscox to have a high P/E ratio.
Investors have an opportunity when market expectations about a stock are wrong. People often underestimate remarkable growth — so investors can make money when fast growth is not fully appreciated. 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 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.
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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.