This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll show how you can use Evans Dixon Limited's (ASX:ED1) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Evans Dixon's P/E ratio is 11.63. In other words, at today's prices, investors are paying A$11.63 for every A$1 in prior year profit.
View our latest analysis for Evans Dixon
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 Evans Dixon:
P/E of 11.63 = A$0.88 ÷ A$0.08 (Based on the trailing twelve months to June 2019.)
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.
Does Evans Dixon Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Evans Dixon has a lower P/E than the average (22.0) P/E for companies in the capital markets industry.
This suggests that market participants think Evans Dixon will underperform other companies in its industry. Since the market seems unimpressed with Evans Dixon, it's quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. And in that case, the P/E ratio itself will drop rather quickly. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Evans Dixon's earnings per share fell by 35% in the last twelve months.
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. Thus, the metric does not reflect cash or debt held by the company. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
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.