Here's How P/E Ratios Can Help Us Understand Royal Mail plc (LON:RMG)

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This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we'll show how Royal Mail plc's (LON:RMG) P/E ratio could help you assess the value on offer. What is Royal Mail's P/E ratio? Well, based on the last twelve months it is 12.1. In other words, at today's prices, investors are paying £12.1 for every £1 in prior year profit.

View our latest analysis for Royal Mail

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Royal Mail:

P/E of 12.1 = £2.12 ÷ £0.17 (Based on the trailing twelve months to March 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. 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

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. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.

Royal Mail shrunk earnings per share by 31% over the last year. And EPS is down 33% a year, over the last 5 years. This could justify a pessimistic P/E.

How Does Royal Mail'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 (16.7) for companies in the logistics industry is higher than Royal Mail's P/E.

Its relatively low P/E ratio indicates that Royal Mail shareholders think it will struggle to do as well as other companies in its industry classification.

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. 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.

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.

How Does Royal Mail's Debt Impact Its P/E Ratio?

Royal Mail's net debt is 15% of its market cap. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.

The Verdict On Royal Mail's P/E Ratio

Royal Mail has a P/E of 12.1. That's below the average in the GB market, which is 16.3. The debt levels are not a major concern, but the lack of EPS growth is likely weighing on sentiment.

Investors should be looking to buy stocks that the market is wrong about. 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 report on the analyst consensus forecasts could help you make a master move on this stock.

Of course you might be able to find a better stock than Royal Mail. So you may wish to see this free collection of other companies that have grown earnings strongly.

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 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. Thank you for reading.