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 Gear4music (Holdings) plc’s (LON:G4M) P/E ratio could help you assess the value on offer. Gear4music (Holdings) has a P/E ratio of 37.09, based on the last twelve months. In other words, at today’s prices, investors are paying £37.09 for every £1 in prior year profit.
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How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Gear4music (Holdings):
P/E of 37.09 = £1.8 ÷ £0.049 (Based on the year to August 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 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. Earnings growth means that in the future the ‘E’ will be higher. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.
Gear4music (Holdings)’s earnings per share fell by 37% in the last twelve months. But it has grown its earnings per share by 58% per year over the last five years.
How Does Gear4music (Holdings)’s P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Gear4music (Holdings) has a significantly higher P/E than the average (11.5) P/E for companies in the specialty retail industry.
That means that the market expects Gear4music (Holdings) will outperform other companies in its industry. Clearly the market expects growth, but it isn’t guaranteed. So further research is always essential. I often monitor director buying and selling.
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. 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).
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).
How Does Gear4music (Holdings)’s Debt Impact Its P/E Ratio?
Gear4music (Holdings)’s net debt is 20% of its market cap. That’s enough debt to impact the P/E ratio a little; so keep it in mind if you’re comparing it to companies without debt.
The Bottom Line On Gear4music (Holdings)’s P/E Ratio
Gear4music (Holdings) trades on a P/E ratio of 37.1, which is above the GB market average of 15.8. With some debt but no EPS growth last year, the market has high expectations of future profits.
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 they key to an excellent investment decision.
But note: Gear4music (Holdings) 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).
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 firstname.lastname@example.org.