Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at Reckon Limited's (ASX:RKN) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, Reckon has a P/E ratio of 10.33. That means that at current prices, buyers pay A$10.33 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 Reckon:
P/E of 10.33 = A$0.70 ÷ A$0.068 (Based on the year to December 2018.)
Is A High P/E Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
How Does Reckon's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. If you look at the image below, you can see Reckon has a lower P/E than the average (37.5) in the software industry classification.
This suggests that market participants think Reckon will underperform other companies in its industry. Since the market seems unimpressed with Reckon, it's quite possible it could surprise on the upside. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means unless the share price falls, the P/E will increase in a few years. Then, a higher P/E might scare off shareholders, pushing the share price down.
Reckon saw earnings per share improve by -3.1% last year. Unfortunately, earnings per share are down 13% a year, over 5 years.
Remember: P/E Ratios Don't Consider The Balance Sheet
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. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on 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.
Reckon's Balance Sheet
Reckon has net debt worth 53% of its market capitalization. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.
The Bottom Line On Reckon's P/E Ratio
Reckon has a P/E of 10.3. That's below the average in the AU market, which is 16.2. The meaningful debt load is probably contributing to low expectations, even though it has improved earnings recently.
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 visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course you might be able to find a better stock than Reckon. So you may wish to see this free collection of other companies that have grown earnings strongly.
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.