The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how Saracen Mineral Holdings Limited's (ASX:SAR) P/E ratio could help you assess the value on offer. What is Saracen Mineral Holdings's P/E ratio? Well, based on the last twelve months it is 28.85. That is equivalent to an earnings yield of about 3.5%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Saracen Mineral Holdings:
P/E of 28.85 = A$2.56 ÷ A$0.089 (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. 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 Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Saracen Mineral Holdings increased earnings per share by an impressive 21% over the last twelve months. And earnings per share have improved by 66% annually, over the last three years. This could arguably justify a relatively high P/E ratio.
Does Saracen Mineral Holdings Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio indicates whether the market has higher or lower expectations of a company. As you can see below, Saracen Mineral Holdings has a higher P/E than the average company (12.6) in the metals and mining industry.
Saracen Mineral Holdings's P/E tells us that market participants think the company will perform better than its industry peers, going forward. 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.
Remember: P/E Ratios Don't Consider The Balance Sheet
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
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.
So What Does Saracen Mineral Holdings's Balance Sheet Tell Us?
Since Saracen Mineral Holdings holds net cash of AU$113m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Saracen Mineral Holdings's P/E Ratio
Saracen Mineral Holdings trades on a P/E ratio of 28.9, which is above the AU market average of 16.2. With cash in the bank the company has plenty of growth options -- and it is already on the right track. 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. 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.' 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 Saracen Mineral Holdings. 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.