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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 look at Austal Limited's (ASX:ASB) P/E ratio and reflect on what it tells us about the company's share price. Austal has a P/E ratio of 30.99, based on the last twelve months. That corresponds to an earnings yield of approximately 3.2%.
Check out our latest analysis for Austal
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Austal:
P/E of 30.99 = A$3.5 ÷ A$0.11 (Based on the trailing twelve months to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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 Does Austal's P/E Ratio Compare To Its Peers?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. You can see in the image below that the average P/E (31.1) for companies in the aerospace & defense industry is roughly the same as Austal's P/E.
Austal's P/E tells us that market participants think its prospects are roughly in line with its industry. The company could surprise by performing better than average, in the future. Further research into factors such as insider buying and selling, could help you form your own view on whether that is likely.
How Growth Rates Impact P/E Ratios
When earnings fall, the 'E' decreases, over time. That means even if the current P/E is low, it will increase over time if the share price stays flat. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
Notably, Austal grew EPS by a whopping 34% in the last year. But earnings per share are down 1.6% per year over the last three years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.