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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 Ariana Resources plc's (LON:AAU) P/E ratio could help you assess the value on offer. Ariana Resources has a P/E ratio of 9.88, based on the last twelve months. In other words, at today's prices, investors are paying £9.88 for every £1 in prior year profit.
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 Ariana Resources:
P/E of 9.88 = £0.021 ÷ £0.0021 (Based on the year to December 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each £1 of company earnings. 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 Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. 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. Then, a lower P/E should attract more buyers, pushing the share price up.
Ariana Resources's earnings made like a rocket, taking off 385% last year.
Does Ariana Resources Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Ariana Resources has a higher P/E than the average (8.9) P/E for companies in the metals and mining industry.
Ariana Resources's P/E tells us that market participants think the company will perform better than its industry peers, going forward. 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.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. 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.
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.
Is Debt Impacting Ariana Resources's P/E?
Ariana Resources has net cash of UK£973k. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Bottom Line On Ariana Resources's P/E Ratio
Ariana Resources trades on a P/E ratio of 9.9, which is below the GB market average of 16.1. Not only should the net cash position reduce risk, but the recent growth has been impressive. The below average P/E ratio suggests that market participants don't believe the strong growth will continue.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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: Ariana Resources 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 email@example.com. 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.