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Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at Ricardo plc's (LON:RCDO) P/E ratio and reflect on what it tells us about the company's share price. What is Ricardo's P/E ratio? Well, based on the last twelve months it is 21.47. In other words, at today's prices, investors are paying £21.47 for every £1 in prior year profit.
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 Ricardo:
P/E of 21.47 = £7.52 ÷ £0.35 (Based on the trailing twelve months to December 2018.)
Is A High Price-to-Earnings Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing 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. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.
Ricardo saw earnings per share decrease by 20% last year. And EPS is down 1.1% a year, over the last 5 years. This could justify a pessimistic P/E.
Does Ricardo 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. You can see in the image below that the average P/E (18.7) for companies in the professional services industry is lower than Ricardo's P/E.
That means that the market expects Ricardo will outperform other companies in its industry. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
How Does Ricardo's Debt Impact Its P/E Ratio?
Net debt totals just 6.9% of Ricardo's market cap. The market might award it a higher P/E ratio if it had net cash, but its unlikely this low level of net borrowing is having a big impact on the P/E multiple.
The Verdict On Ricardo's P/E Ratio
Ricardo's P/E is 21.5 which is above average (16.2) in the GB market. With modest debt but no EPS growth in the last year, it's fair to say the P/E implies some optimism about future earnings, from the market.
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 Ricardo. 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.