This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Resources Connection, Inc.’s (NASDAQ:RECN) P/E ratio could help you assess the value on offer. Resources Connection has a price to earnings ratio of 22.06, based on the last twelve months. That is equivalent to an earnings yield of about 4.5%.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Resources Connection:
P/E of 22.06 = $17.36 ÷ $0.79 (Based on the year to November 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. All else being equal, it’s better to pay a low price — but as Warren Buffett said, ‘It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.’
How Growth Rates Impact P/E Ratios
Companies that shrink earnings per share quickly will rapidly decrease the ‘E’ in the equation. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
It’s nice to see that Resources Connection grew EPS by a stonking 34% in the last year. And its annual EPS growth rate over 5 years is 3.4%. I’d therefore be a little surprised if its P/E ratio was not relatively high. In contrast, EPS has decreased by 7.0%, annually, over 3 years.
How Does Resources Connection’s P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. As you can see below Resources Connection has a P/E ratio that is fairly close for the average for the professional services industry, which is 22.8.
Its P/E ratio suggests that Resources Connection shareholders think that in the future it will perform about the same as other companies in its industry classification. The company could surprise by performing better than average, in the future. Checking factors such as the tenure of the board and management could help you form your own view on if that will happen.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn’t take debt or cash into account. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining cash).
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 Resources Connection’s Debt Impact Its P/E Ratio?
Resources Connection’s net debt is 3.1% of its market cap. 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 Resources Connection’s P/E Ratio
Resources Connection’s P/E is 22.1 which is above average (17.5) in the US market. The company is not overly constrained by its modest debt levels, and it is growing earnings per share. Therefore it seems reasonable that the market would have relatively high expectations of the company
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 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 Resources Connection. 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).
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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.