In This Article:
This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Energy Action Limited’s (ASX:EAX) P/E ratio could help you assess the value on offer. Energy Action has a price to earnings ratio of 3.61, based on the last twelve months. In other words, at today’s prices, investors are paying A$3.61 for every A$1 in prior year profit.
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How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Energy Action:
P/E of 3.61 = A$0.36 ÷ A$0.10 (Based on the trailing twelve months to June 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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. When earnings grow, the ‘E’ increases, over time. 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.
It’s nice to see that Energy Action grew EPS by a stonking 46% in the last year. And it has improved its earnings per share by 116% per year over the last three years. So we’d generally expect it to have a relatively high P/E ratio. But earnings per share are down 18% per year over the last five years.
How Does Energy Action’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Energy Action has a lower P/E than the average (21.7) P/E for companies in the professional services industry.
This suggests that market participants think Energy Action will underperform other companies in its industry. Many investors like to buy stocks when the market is pessimistic about their prospects. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
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. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining cash).