This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll show how you can use PWR Holdings Limited's (ASX:PWH) P/E ratio to inform your assessment of the investment opportunity. What is PWR Holdings's P/E ratio? Well, based on the last twelve months it is 35.20. That means that at current prices, buyers pay A$35.20 for every A$1 in trailing yearly profits.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for PWR Holdings:
P/E of 35.20 = AUD5.00 ÷ AUD0.14 (Based on the year to June 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each AUD1 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 Does PWR Holdings's P/E Ratio Compare To Its Peers?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. The image below shows that PWR Holdings has a higher P/E than the average (15.7) P/E for companies in the auto components industry.
Its relatively high P/E ratio indicates that PWR Holdings shareholders think it will perform better than other companies in its industry classification. Clearly the market expects growth, but it isn't guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. 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.
PWR Holdings increased earnings per share by a whopping 29% last year. And it has bolstered its earnings per share by 15% per year over the last five years. So we'd generally expect it to have a relatively high P/E ratio.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
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. 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.
PWR Holdings's Balance Sheet
The extra options and safety that comes with PWR Holdings's AU$17m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Verdict On PWR Holdings's P/E Ratio
PWR Holdings has a P/E of 35.2. That's higher than the average in its market, which is 19.0. Its strong balance sheet gives the company plenty of resources for extra growth, and it has already proven it can grow. So it does not seem strange that the P/E is above average.
Investors have an opportunity when market expectations about a stock are wrong. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
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.
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