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Here’s What AGL Energy Limited’s (ASX:AGL) P/E Ratio Is Telling Us

The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we’ll show how AGL Energy Limited’s (ASX:AGL) P/E ratio could help you assess the value on offer. AGL Energy has a P/E ratio of 7.54, based on the last twelve months. That means that at current prices, buyers pay A\$7.54 for every A\$1 in trailing yearly profits.

How Do You Calculate AGL Energy’s P/E Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for AGL Energy:

P/E of 7.54 = A\$18.25 ÷ A\$2.42 (Based on the year to June 2018.)

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. 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 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. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.

It’s nice to see that AGL Energy grew EPS by a stonking 200% in the last year. And earnings per share have improved by 17% annually, over the last five years. I’d therefore be a little surprised if its P/E ratio was not relatively high.

How Does AGL Energy’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 (17) for companies in the integrated utilities industry is higher than AGL Energy’s P/E.

AGL Energy’s P/E tells us that market participants think it will not fare as well as its peers in the same industry. Many investors like to buy stocks when the market is pessimistic about their prospects. You should delve deeper. I like to check if company insiders have been buying or selling.

Remember: P/E Ratios Don’t Consider The Balance Sheet

Don’t forget that the P/E ratio considers market capitalization. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

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).

AGL Energy’s Balance Sheet

AGL Energy’s net debt is 21% of its market cap. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.

The Verdict On AGL Energy’s P/E Ratio

AGL Energy’s P/E is 7.5 which is below average (15.4) in the AU market. The company hasn’t stretched its balance sheet, and earnings growth was good last year. If it continues to grow, then the current low P/E may prove to be unjustified.

Investors should be looking to buy stocks that the market is wrong about. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

Of course you might be able to find a better stock than AGL Energy. So you may wish to see this free collection of other companies that have grown earnings strongly.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.