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 United Carpets Group PLC’s (LON:UCG) P/E ratio could help you assess the value on offer. United Carpets Group has a P/E ratio of 4.52, based on the last twelve months. That means that at current prices, buyers pay £4.52 for every £1 in trailing yearly profits.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for United Carpets Group:
P/E of 4.52 = £0.071 ÷ £0.016 (Based on the trailing twelve months to March 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. When earnings grow, the ‘E’ increases, over time. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
United Carpets Group maintained roughly steady earnings over the last twelve months. But over the longer term (5 years) earnings per share have increased by 15%.
How Does United Carpets Group’s P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. We can see in the image below that the average P/E (11) for companies in the specialty retail industry is higher than United Carpets Group’s P/E.
This suggests that market participants think United Carpets Group will underperform other companies in its industry. Many investors like to buy stocks when the market is pessimistic about their prospects. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
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. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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).
United Carpets Group’s Balance Sheet
United Carpets Group has net cash of UK£3m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Verdict On United Carpets Group’s P/E Ratio
United Carpets Group has a P/E of 4.5. That’s below the average in the GB market, which is 16.4. The recent drop in earnings per share would almost certainly temper expectations, the healthy balance sheet means the company retains potential for future growth. If that occurs, the current low P/E could prove to be temporary.
When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. 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.
You might be able to find a better buy than United Carpets 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).
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.