Today, we’ll introduce the concept of the P/E ratio for those who are learning about investing. We’ll apply a basic P/E ratio analysis to Chichibu Railway Co., Ltd.’s (TYO:9012), to help you decide if the stock is worth further research. Based on the last twelve months, Chichibu Railway’s P/E ratio is 42.80. That corresponds to an earnings yield of approximately 2.3%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Chichibu Railway:
P/E of 42.80 = JPY2478.00 ÷ JPY57.90 (Based on the year to December 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each JPY1 of company earnings. 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 Chichibu Railway 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. The image below shows that Chichibu Railway has a significantly higher P/E than the average (12.7) P/E for companies in the transportation industry.
Its relatively high P/E ratio indicates that Chichibu Railway shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn’t guarantee future growth. So investors should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Companies that shrink earnings per share quickly will rapidly decrease the ‘E’ in the equation. That means even if the current P/E is low, it will increase over time if the share price stays flat. A higher P/E should indicate the stock is expensive relative to others — and that may encourage shareholders to sell.
It’s great to see that Chichibu Railway grew EPS by 12% in the last year. And earnings per share have improved by 21% annually, over the last five years. This could arguably justify a relatively high P/E ratio. But earnings per share are down 21% per year over the last three years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
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.
Chichibu Railway’s Balance Sheet
Chichibu Railway’s net debt is 96% of its market cap. This is enough debt that you’d have to make some adjustments before using the P/E ratio to compare it to a company with net cash.
The Verdict On Chichibu Railway’s P/E Ratio
Chichibu Railway trades on a P/E ratio of 42.8, which is above its market average of 15.3. It’s good to see the recent earnings growth, although we note the company uses debt already. The relatively high P/E ratio suggests shareholders think growth will continue.
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. Although we don’t have analyst forecasts shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
But note: Chichibu Railway 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).
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.
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