This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we'll show how Vital Limited's (NZSE:VTL) P/E ratio could help you assess the value on offer. Based on the last twelve months, Vital's P/E ratio is 6.95. In other words, at today's prices, investors are paying NZ$6.95 for every NZ$1 in prior year profit.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Vital:
P/E of 6.95 = NZ$0.78 ÷ NZ$0.11 (Based on the trailing twelve months to June 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
Does Vital 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. The image below shows that Vital has a lower P/E than the average (15.9) P/E for companies in the wireless telecom industry.
This suggests that market participants think Vital will underperform other companies in its industry. Since the market seems unimpressed with Vital, it's quite possible it could surprise on the upside. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
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. When earnings grow, the 'E' increases, over time. 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.
Vital's earnings per share fell by 29% in the last twelve months.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
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. 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 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 Vital's Debt Impact Its P/E Ratio?
Vital has net debt equal to 34% of its market cap. While that's enough to warrant consideration, it doesn't really concern us.
The Verdict On Vital's P/E Ratio
Vital has a P/E of 7.0. That's below the average in the NZ market, which is 19.0. The debt levels are not a major concern, but the lack of EPS growth is likely weighing on sentiment.
When the market is wrong about a stock, it gives savvy investors an opportunity. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. Although we don't have analyst forecasts shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
But note: Vital may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio 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.
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. Thank you for reading.