In This Article:
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 Servcorp Limited's (ASX:SRV) P/E ratio could help you assess the value on offer. Based on the last twelve months, Servcorp's P/E ratio is 78.28. In other words, at today's prices, investors are paying A$78.28 for every A$1 in prior year profit.
Check out our latest analysis for Servcorp
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Servcorp:
P/E of 78.28 = A$4.35 ÷ A$0.06 (Based on the trailing twelve months to June 2019.)
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 Does Servcorp's P/E Ratio Compare To Its Peers?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. You can see in the image below that the average P/E (12.9) for companies in the real estate industry is a lot lower than Servcorp's P/E.
Servcorp's P/E tells us that market participants think the company will perform better than its industry peers, going forward. The market is optimistic about the future, but that doesn't guarantee future growth. So further research is always essential. I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
If earnings fall then in the future the 'E' will be lower. That means even if the current P/E is low, it will increase over time if the share price stays flat. Then, a higher P/E might scare off shareholders, pushing the share price down.
Servcorp shrunk earnings per share by 46% over the last year. And over the longer term (5 years) earnings per share have decreased 27% annually. This might lead to muted expectations.
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. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.