Today, we’ll introduce the concept of the P/E ratio for those who are learning about investing. We’ll look at Scales Corporation Limited’s (NZSE:SCL) P/E ratio and reflect on what it tells us about the company’s share price. Based on the last twelve months, Scales’s P/E ratio is 24.45. That corresponds to an earnings yield of approximately 4.1%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Scales:
P/E of 24.45 = NZ$5 ÷ NZ$0.20 (Based on the year to December 2018.)
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 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
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.
It’s great to see that Scales grew EPS by 18% in the last year. And its annual EPS growth rate over 5 years is 4.9%. So one might expect an above average P/E ratio. Unfortunately, earnings per share are down 7.3% a year, over 3 years.
How Does Scales’s P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. As you can see below Scales has a P/E ratio that is fairly close for the average for the food industry, which is 24.6.
Its P/E ratio suggests that Scales shareholders think that in the future it will perform about the same as other companies in its industry classification. If the company has better than average prospects, then the market might be underestimating it. Checking factors such as the tenure of the board and management could help you form your own view on if that will happen.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
Don’t forget that the P/E ratio considers market capitalization. So it won’t reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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.
So What Does Scales’s Balance Sheet Tell Us?
Net debt totals just 9.9% of Scales’s market cap. It would probably trade on a higher P/E ratio if it had a lot of cash, but I doubt it is having a big impact.
The Verdict On Scales’s P/E Ratio
Scales has a P/E of 24.4. That’s higher than the average in the NZ market, which is 17.4. While the company does use modest debt, its recent earnings growth is very good. So on this analysis it seems reasonable that its P/E ratio is above average.
When the market is wrong about a stock, it gives savvy investors an opportunity. People often underestimate remarkable growth — so investors can make money when fast growth is not fully appreciated. 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.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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 email@example.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.