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 Ordina N.V.’s (AMS:ORDI) P/E ratio could help you assess the value on offer. Ordina has a P/E ratio of 18.6, based on the last twelve months. That corresponds to an earnings yield of approximately 5.4%.
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How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Ordina:
P/E of 18.6 = €1.43 ÷ €0.077 (Based on the year to June 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 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. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.
Ordina increased earnings per share by a whopping 129% last year. And it has bolstered its earnings per share by 73% per year over the last five years. I’d therefore be a little surprised if its P/E ratio was not relatively high.
How Does Ordina’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 Ordina has a P/E ratio that is roughly in line with the it industry average (18.7).
That indicates that the market expects Ordina 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 inform my view byby checking management tenure and remuneration, among other things.
Remember: P/E Ratios Don’t Consider The Balance Sheet
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. 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).
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
Ordina’s Balance Sheet
Since Ordina holds net cash of €2.9m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Ordina’s P/E Ratio
Ordina trades on a P/E ratio of 18.6, which is above the NL market average of 14.8. With cash in the bank the company has plenty of growth options — and it is already on the right track. So it does not seem strange that the P/E is above average.
Investors have an opportunity when market expectations about a stock are wrong. 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 report on the analyst consensus forecasts could help you make a master move on this stock.
But note: Ordina 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 editorial-team@simplywallst.com.