The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at Lucara Diamond Corp.'s (TSE:LUC) P/E ratio and reflect on what it tells us about the company's share price. Lucara Diamond has a price to earnings ratio of 16.82, based on the last twelve months. That is equivalent to an earnings yield of about 5.9%.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)
Or for Lucara Diamond:
P/E of 16.82 = $1.1 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $0.066 (Based on the trailing twelve months to March 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each CA$1 the company has earned over the last year. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
Does Lucara Diamond Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Lucara Diamond has a P/E ratio that is roughly in line with the metals and mining industry average (16.6).
That indicates that the market expects Lucara Diamond will perform roughly in line with other companies in its industry. If the company has better than average prospects, then the market might be underestimating it. Further research into factors such as insider buying and selling, could help you form your own view on whether that is likely.
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. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
Lucara Diamond shrunk earnings per share by 58% over the last year. And EPS is down 17% a year, over the last 5 years. This growth rate might warrant a below average P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. 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.
So What Does Lucara Diamond's Balance Sheet Tell Us?
Since Lucara Diamond holds net cash of US$18m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Lucara Diamond's P/E Ratio
Lucara Diamond has a P/E of 16.8. That's higher than the average in its market, which is 14.4. The recent drop in earnings per share would make some investors cautious, but the healthy balance sheet means the company retains potential for future growth. If fails to eventuate, the current high P/E could prove to be temporary, as the share price falls.
Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
You might be able to find a better buy than Lucara Diamond. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
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.