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Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how Eurocell plc's (LON:ECEL) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, Eurocell has a P/E ratio of 10.84. That corresponds to an earnings yield of approximately 9.2%.
See our latest analysis for Eurocell
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 Eurocell:
P/E of 10.84 = £2.12 ÷ £0.20 (Based on the trailing twelve months to December 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each £1 the company has earned over the last year. 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 Eurocell Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. We can see in the image below that the average P/E (13) for companies in the building industry is higher than Eurocell's P/E.
This suggests that market participants think Eurocell 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
Earnings growth rates have a big influence on P/E ratios. When earnings grow, the 'E' increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Eurocell maintained roughly steady earnings over the last twelve months. But over the longer term (3 years), earnings per share have increased by 8.0%.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. That means it doesn't take debt or cash into account. 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.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).