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 RSA Insurance Group plc’s (LON:RSA) P/E ratio could help you assess the value on offer. RSA Insurance Group has a P/E ratio of 17.85, based on the last twelve months. In other words, at today’s prices, investors are paying £17.85 for every £1 in prior year profit.
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How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for RSA Insurance Group:
P/E of 17.85 = £5.67 ÷ £0.32 (Based on the year to December 2018.)
Is A High Price-to-Earnings Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
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. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
RSA Insurance Group increased earnings per share by an impressive 21% over the last twelve months. And it has improved its earnings per share by 66% per year over the last three years. So one might expect an above average P/E ratio.
Does RSA Insurance Group Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. You can see in the image below that the average P/E (15.7) for companies in the insurance industry is lower than RSA Insurance Group’s P/E.
RSA Insurance Group’s P/E tells us that market participants think the company will perform better than its industry peers, going forward. The market is optimistic about the future, but that doesn’t guarantee future growth. So further research is always essential. I often monitor director buying and selling.
Remember: P/E Ratios Don’t Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
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.
So What Does RSA Insurance Group’s Balance Sheet Tell Us?
Since RSA Insurance Group holds net cash of UK£247m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On RSA Insurance Group’s P/E Ratio
RSA Insurance Group’s P/E is 17.8 which is above average (16.3) in the GB market. Its strong balance sheet gives the company plenty of resources for extra growth, and it has already proven it can grow. Therefore it seems reasonable that the market would have relatively high expectations of the company
When the market is wrong about a stock, it gives savvy investors an opportunity. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.
You might be able to find a better buy than RSA Insurance Group. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
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.