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Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use Cervus Equipment Corporation's (TSE:CERV) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Cervus Equipment's P/E ratio is 7.48. That means that at current prices, buyers pay CA$7.48 for every CA$1 in trailing yearly profits.
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 Cervus Equipment:
P/E of 7.48 = CA$11.5 ÷ CA$1.54 (Based on the trailing twelve months to March 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 Cervus Equipment'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 (12.5) for companies in the trade distributors industry is higher than Cervus Equipment's P/E.
Its relatively low P/E ratio indicates that Cervus Equipment shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Cervus Equipment, it's quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
It's great to see that Cervus Equipment grew EPS by 13% in the last year.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
The 'Price' in P/E reflects the market capitalization of the company. 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.
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
Cervus Equipment's Balance Sheet
Cervus Equipment has net debt worth a very significant 190% of its market capitalization. If you want to compare its P/E ratio to other companies, you must keep in mind that these debt levels would usually warrant a relatively low P/E.
The Bottom Line On Cervus Equipment's P/E Ratio
Cervus Equipment has a P/E of 7.5. That's below the average in the CA market, which is 15. The company may have significant debt, but EPS growth was good last year. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
But note: Cervus Equipment 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.