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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 SEVAK Limited’s (SGX:BAI) P/E ratio could help you assess the value on offer. SEVAK has a price to earnings ratio of 11.18, based on the last twelve months. In other words, at today’s prices, investors are paying SGD11.18 for every SGD1 in prior year profit.
See our latest analysis for SEVAK
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 SEVAK:
P/E of 11.18 = SGD3.5 ÷ SGD0.31 (Based on the trailing twelve months to December 2018.)
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 a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business’s prospects, relative to stocks with a lower P/E.
How Growth Rates Impact P/E Ratios
If earnings fall then in the future the ‘E’ will be lower. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. Then, a higher P/E might scare off shareholders, pushing the share price down.
It’s nice to see that SEVAK grew EPS by a stonking 440% in the last year. And its annual EPS growth rate over 5 years is 62%. With that performance, I would expect it to have an above average P/E ratio. In contrast, EPS has decreased by 8.0%, annually, over 3 years.
How Does SEVAK’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. We can see in the image below that the average P/E (14.5) for companies in the wireless telecom industry is higher than SEVAK’s P/E.
SEVAK’s P/E tells us that market participants think it will not fare as well as its peers in the same industry. Since the market seems unimpressed with SEVAK, 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.
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. That means it doesn’t take debt or cash into account. 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).
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.