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 SP Corporation Limited's (SGX:AWE) P/E ratio could help you assess the value on offer. SP has a P/E ratio of 7.03, based on the last twelve months. That is equivalent to an earnings yield of about 14.2%.
Check out our latest analysis for SP
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 SP:
P/E of 7.03 = SGD0.51 ÷ SGD0.07 (Based on the year to September 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each SGD1 of company earnings. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
Does SP Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. The image below shows that SP has a lower P/E than the average (11.4) P/E for companies in the trade distributors industry.
This suggests that market participants think SP will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. 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. 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. Then, a lower P/E should attract more buyers, pushing the share price up.
SP's earnings made like a rocket, taking off 86% last year. Having said that, the average EPS growth over the last three years wasn't so good, coming in at 13%.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The 'Price' in P/E reflects the market capitalization of the company. That means it doesn't take debt or cash into account. 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.
How Does SP's Debt Impact Its P/E Ratio?
Net debt totals 18% of SP's market cap. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.