This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we'll show how Advance NanoTek Limited's (ASX:ANO) P/E ratio could help you assess the value on offer. Advance NanoTek has a price to earnings ratio of 28.69, based on the last twelve months. That is equivalent to an earnings yield of about 3.5%.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Advance NanoTek:
P/E of 28.69 = A$4.85 ÷ A$0.17 (Based on the trailing twelve months to June 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each A$1 of company earnings. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.'
How Does Advance NanoTek'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 (25.7) for companies in the chemicals industry is lower than Advance NanoTek's P/E.
Advance NanoTek'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
Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the 'E' will be higher. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
In the last year, Advance NanoTek grew EPS like Taylor Swift grew her fan base back in 2010; the 266% gain was both fast and well deserved. The sweetener is that the annual five year growth rate of 212% is also impressive. With that kind of growth rate we would generally expect a high P/E ratio.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
Don't forget that the P/E ratio considers market capitalization. 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.
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.
Advance NanoTek's Balance Sheet
The extra options and safety that comes with Advance NanoTek's AU$353k net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Verdict On Advance NanoTek's P/E Ratio
Advance NanoTek trades on a P/E ratio of 28.7, which is above its market average of 17.9. The excess cash it carries is the gravy on top its fast EPS growth. To us, this is the sort of company that we would expect to carry an above average price tag (relative to earnings).
When the market is wrong about a stock, it gives savvy investors an opportunity. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine.' We don't have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.
But note: Advance NanoTek may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.