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This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we'll show how Clean Seas Seafood Limited's (ASX:CSS) P/E ratio could help you assess the value on offer. Clean Seas Seafood has a price to earnings ratio of 28.3, based on the last twelve months. That is equivalent to an earnings yield of about 3.5%.
Check out our latest analysis for Clean Seas Seafood
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 Clean Seas Seafood:
P/E of 28.3 = A$0.96 ÷ A$0.034 (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 A$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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Notably, Clean Seas Seafood grew EPS by a whopping 86% in the last year. And earnings per share have improved by 116% annually, over the last three years. With that performance, I would expect it to have an above average P/E ratio. Unfortunately, earnings per share are down 31% a year, over 5 years.
How Does Clean Seas Seafood's P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. You can see in the image below that the average P/E (20.1) for companies in the food industry is lower than Clean Seas Seafood's P/E.
That means that the market expects Clean Seas Seafood will outperform other companies in its industry. Shareholders are clearly optimistic, but the future is always uncertain. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The 'Price' in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.