This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We’ll apply a basic P/E ratio analysis to Farmmi, Inc.’s (NASDAQ:FAMI), to help you decide if the stock is worth further research. Farmmi has a price to earnings ratio of 7.53, based on the last twelve months. That means that at current prices, buyers pay $7.53 for every $1 in trailing yearly profits.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Farmmi:
P/E of 7.53 = $2.17 ÷ $0.29 (Based on the year to September 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each $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
Generally speaking the rate of earnings growth has a profound impact on a company’s P/E multiple. When earnings grow, the ‘E’ increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Farmmi shrunk earnings per share by 12% over the last year. But it has grown its earnings per share by 31% per year over the last five years.
Does Farmmi 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. We can see in the image below that the average P/E (21.8) for companies in the food industry is higher than Farmmi’s P/E.
Farmmi’s P/E tells us that market participants think it will not fare as well as its peers in the same industry. Since the market seems unimpressed with Farmmi, it’s quite possible it could surprise on the upside. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn’t take debt or cash into account. 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).
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).
How Does Farmmi’s Debt Impact Its P/E Ratio?
Farmmi has net cash of US$2.7m. This is fairly high at 10% of its market capitalization. That might mean balance sheet strength is important to the business, but should also help push the P/E a bit higher than it would otherwise be.
The Verdict On Farmmi’s P/E Ratio
Farmmi trades on a P/E ratio of 7.5, which is below the US market average of 18.1. Falling earnings per share are likely to be keeping potential buyers away, the relatively strong balance sheet will allow the company time to invest in growth. If it achieves that, then there’s real potential that the low P/E could eventually indicate undervaluation.
Investors should be looking to buy stocks that the market is wrong about. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. We don’t have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than Farmmi. 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.