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 Scott Technology Limited's (NZSE:SCT) P/E ratio could help you assess the value on offer. Scott Technology has a P/E ratio of 19.90, based on the last twelve months. That means that at current prices, buyers pay NZ$19.90 for every NZ$1 in trailing yearly profits.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Scott Technology:
P/E of 19.90 = NZ$2.23 ÷ NZ$0.11 (Based on the trailing twelve months to August 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 necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Does Scott Technology's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Scott Technology has a higher P/E than the average (15.3) P/E for companies in the machinery industry.
Its relatively high P/E ratio indicates that Scott Technology shareholders think it will perform better than other companies in its industry classification. Clearly the market expects growth, but it isn't guaranteed. So further research is always essential. I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
If earnings fall then in the future the 'E' will be lower. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. Then, a higher P/E might scare off shareholders, pushing the share price down.
Scott Technology saw earnings per share decrease by 22% last year. But over the longer term (5 years) earnings per share have increased by 13%. And over the longer term (3 years) earnings per share have decreased 5.5% annually. This could justify a low P/E.
Remember: P/E Ratios Don't Consider The Balance Sheet
The 'Price' in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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.
How Does Scott Technology's Debt Impact Its P/E Ratio?
Scott Technology has net debt worth just 2.3% of its market capitalization. So it doesn't have as many options as it would with net cash, but its debt would not have much of an impact on its P/E ratio.
The Bottom Line On Scott Technology's P/E Ratio
Scott Technology has a P/E of 19.9. That's around the same as the average in the NZ market, which is 19.4. When you consider the lack of EPS growth last year (along with some debt), it seems the market is optimistic about the future for the business.
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 could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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.
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. Thank you for reading.