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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 Rocky Mountain Chocolate Factory, Inc.’s (NASDAQ:RMCF) P/E ratio could help you assess the value on offer. Rocky Mountain Chocolate Factory has a P/E ratio of 23.35, based on the last twelve months. That corresponds to an earnings yield of approximately 4.3%.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Rocky Mountain Chocolate Factory:
P/E of 23.35 = $9.17 ÷ $0.39 (Based on the year to November 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each $1 the company has earned over the last year. 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
If earnings fall then in the future the ‘E’ will be lower. That means unless the share price falls, the P/E will increase in a few years. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
Rocky Mountain Chocolate Factory shrunk earnings per share by 29% over the last year. And it has shrunk its earnings per share by 5.4% per year over the last five years. This growth rate might warrant a below average P/E ratio.
How Does Rocky Mountain Chocolate Factory’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (18.7) for companies in the food industry is lower than Rocky Mountain Chocolate Factory’s P/E.
Its relatively high P/E ratio indicates that Rocky Mountain Chocolate Factory shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn’t guarantee future growth. So further research is always essential. I often monitor director buying and selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don’t forget that the P/E ratio considers market capitalization. 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).
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
Rocky Mountain Chocolate Factory’s Balance Sheet
Rocky Mountain Chocolate Factory has net cash of US$2.7m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Verdict On Rocky Mountain Chocolate Factory’s P/E Ratio
Rocky Mountain Chocolate Factory has a P/E of 23.4. That’s higher than the average in the US market, which is 17.5. The recent drop in earnings per share might keep value investors away, but the relatively strong balance sheet will allow the company time to invest in growth. Clearly, the high P/E indicates shareholders think it will!
When the market is wrong about a stock, it gives savvy investors an opportunity. People often underestimate remarkable growth — so investors can make money when fast growth is not fully appreciated. We don’t have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.
But note: Rocky Mountain Chocolate Factory 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).
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.