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Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at Mount Gibson Iron Limited's (ASX:MGX) P/E ratio and reflect on what it tells us about the company's share price. What is Mount Gibson Iron's P/E ratio? Well, based on the last twelve months it is 16.79. In other words, at today's prices, investors are paying A$16.79 for every A$1 in prior year profit.
Check out our latest analysis for Mount Gibson Iron
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 Mount Gibson Iron:
P/E of 16.79 = A$0.98 ÷ A$0.058 (Based on the year 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 necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means unless the share price increases, the P/E will reduce in a few years. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Mount Gibson Iron shrunk earnings per share by 25% over the last year. And it has shrunk its earnings per share by 20% per year over the last five years. This growth rate might warrant a below average P/E ratio.
Does Mount Gibson Iron 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. The image below shows that Mount Gibson Iron has a higher P/E than the average (12) P/E for companies in the metals and mining industry.
Its relatively high P/E ratio indicates that Mount Gibson Iron shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn't guarantee future growth. So investors 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
Don't forget that the P/E ratio considers market capitalization. So it won't reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.