In This Article:
Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at AVJennings Limited's (ASX:AVJ) P/E ratio and reflect on what it tells us about the company's share price. What is AVJennings's P/E ratio? Well, based on the last twelve months it is 15.30. In other words, at today's prices, investors are paying A$15.30 for every A$1 in prior year profit.
See our latest analysis for AVJennings
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for AVJennings:
P/E of 15.30 = A$0.63 ÷ A$0.04 (Based on the trailing twelve months to June 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each A$1 the company has earned over the last year. 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.
Does AVJennings Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (13.6) for companies in the real estate industry is lower than AVJennings's P/E.
Its relatively high P/E ratio indicates that AVJennings shareholders think it will perform better than other companies in its industry classification. Shareholders are clearly optimistic, but the future is always uncertain. So investors should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
When earnings fall, the 'E' decreases, over time. That means unless the share price falls, the P/E will increase in a few years. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.
AVJennings saw earnings per share decrease by 50% last year. And it has shrunk its earnings per share by 3.7% per year over the last five years. This growth rate might warrant a below average P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
The 'Price' in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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).