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This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll show how you can use AWF Madison Group Limited's (NZSE:AWF) P/E ratio to inform your assessment of the investment opportunity. AWF Madison Group has a price to earnings ratio of 30.32, based on the last twelve months. That means that at current prices, buyers pay NZ$30.32 for every NZ$1 in trailing yearly profits.
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 AWF Madison Group:
P/E of 30.32 = NZ$1.85 ÷ NZ$0.061 (Based on the year to March 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each NZ$1 of company earnings. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.
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. Then, a higher P/E might scare off shareholders, pushing the share price down.
AWF Madison Group shrunk earnings per share by 61% over the last year. And it has shrunk its earnings per share by 17% per year over the last five years. This might lead to muted expectations.
How Does AWF Madison Group'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 AWF Madison Group has a higher P/E than the average (20.9) P/E for companies in the professional services industry.
That means that the market expects AWF Madison Group will outperform other companies in its industry. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
Remember: P/E Ratios Don't Consider The Balance Sheet
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. 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.
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).
So What Does AWF Madison Group's Balance Sheet Tell Us?
AWF Madison Group's net debt equates to 43% of its market capitalization. While it's worth keeping this in mind, it isn't a worry.
The Bottom Line On AWF Madison Group's P/E Ratio
AWF Madison Group trades on a P/E ratio of 30.3, which is above the NZ market average of 17.9. 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. Although we don't have analyst forecasts, you could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than AWF Madison 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).
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 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. Thank you for reading.