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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at Meridian Energy Limited's (NZSE:MEL) P/E ratio and reflect on what it tells us about the company's share price. What is Meridian Energy's P/E ratio? Well, based on the last twelve months it is 46.01. That corresponds to an earnings yield of approximately 2.2%.
How Do I Calculate Meridian Energy's Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Meridian Energy:
P/E of 46.01 = NZ$4.38 ÷ NZ$0.095 (Based on the year to December 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each NZ$1 the company has earned over the last year. 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.'
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. When earnings grow, the 'E' increases, over time. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Notably, Meridian Energy grew EPS by a whopping 33% in the last year. And it has improved its earnings per share by 1.4% per year over the last three years. I'd therefore be a little surprised if its P/E ratio was not relatively high.
How Does Meridian Energy's P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. You can see in the image below that the average P/E (16.9) for companies in the renewable energy industry is lower than Meridian Energy's P/E.
Its relatively high P/E ratio indicates that Meridian Energy shareholders think it will perform better than other companies in its industry classification. Clearly the market expects growth, but it isn't guaranteed. So further research is always essential. I often monitor director buying and selling.
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. 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.
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
So What Does Meridian Energy's Balance Sheet Tell Us?
Meridian Energy has net debt worth 14% of its market capitalization. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.
The Verdict On Meridian Energy's P/E Ratio
Meridian Energy's P/E is 46 which is above average (18) in the NZ market. The company is not overly constrained by its modest debt levels, and its recent EPS growth is nothing short of stand-out. So on this analysis a high P/E ratio seems reasonable.
Investors have an opportunity when market expectations about a stock are wrong. 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.' So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
You might be able to find a better buy than Meridian Energy. 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).
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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.