The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we’ll show how RGC Resources, Inc.’s (NASDAQ:RGCO) P/E ratio could help you assess the value on offer. Based on the last twelve months, RGC Resources’s P/E ratio is 31.11. In other words, at today’s prices, investors are paying $31.11 for every $1 in prior year profit.
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How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for RGC Resources:
P/E of 31.11 = $29.68 ÷ $0.95 (Based on the year to September 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. 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
Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the ‘E’ will be higher. That means unless the share price increases, the P/E will reduce in a few years. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
RGC Resources increased earnings per share by an impressive 10% over the last twelve months. And its annual EPS growth rate over 5 years is 8.4%. This could arguably justify a relatively high P/E ratio.
How Does RGC Resources’s P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. As you can see below, RGC Resources has a higher P/E than the average company (17.4) in the gas utilities industry.
Its relatively high P/E ratio indicates that RGC Resources 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.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
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. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
Is Debt Impacting RGC Resources’s P/E?
Net debt totals 29% of RGC Resources’s market cap. This is a reasonably significant level of debt — all else being equal you’d expect a much lower P/E than if it had net cash.
The Bottom Line On RGC Resources’s P/E Ratio
RGC Resources trades on a P/E ratio of 31.1, which is above the US market average of 16.8. The company is not overly constrained by its modest debt levels, and it is growing earnings per share. So it is not surprising the market is probably extrapolating recent growth well into the future, reflected in the relatively high P/E ratio.
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 they key to an excellent investment decision.
You might be able to find a better buy than RGC Resources. 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).
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.