Is Elementis plc's (LON:ELM) P/E Ratio Really That Good?

The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll show how you can use Elementis plc's (LON:ELM) P/E ratio to inform your assessment of the investment opportunity. What is Elementis's P/E ratio? Well, based on the last twelve months it is 23.22. That means that at current prices, buyers pay £23.22 for every £1 in trailing yearly profits.

Check out our latest analysis for Elementis

How Do You Calculate A P/E Ratio?

The formula for P/E is:

Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)

Or for Elementis:

P/E of 23.22 = £2.37 (Note: this is the share price in the reporting currency, namely, USD ) ÷ £0.10 (Based on the year to June 2019.)

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'.

Does Elementis Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (23.3) for companies in the chemicals industry is roughly the same as Elementis's P/E.

That indicates that the market expects Elementis 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. I would further inform my view by checking insider buying and selling., among other things.

How Growth Rates Impact P/E Ratios

Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.

Elementis shrunk earnings per share by 56% over the last year. And over the longer term (5 years) earnings per share have decreased 16% annually. This might lead to muted expectations.

Remember: P/E Ratios Don't Consider The Balance Sheet

The 'Price' in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).

So What Does Elementis's Balance Sheet Tell Us?

Elementis has net debt equal to 37% of its market cap. You'd want to be aware of this fact, but it doesn't bother us.

The Verdict On Elementis's P/E Ratio

Elementis has a P/E of 23.2. That's higher than the average in its market, which is 18.3. With a bit of debt, but a lack of recent growth, it's safe to say the market is expecting improved profit performance from the company, in the next few years.

Investors should be looking to buy stocks that the market is wrong about. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.

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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.

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. Thank you for reading.