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 Origin Energy Limited's (ASX:ORG) P/E ratio could help you assess the value on offer. Origin Energy has a P/E ratio of 10.71, based on the last twelve months. That means that at current prices, buyers pay A$10.71 for every A$1 in trailing yearly profits.
How Do You Calculate Origin Energy's P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Origin Energy:
P/E of 10.71 = A$7.37 ÷ A$0.69 (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 Origin Energy Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. You can see in the image below that the average P/E (7.4) for companies in the oil and gas industry is lower than Origin Energy's P/E.
Origin Energy's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Shareholders are clearly optimistic, but the future is always uncertain. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. 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.
Origin Energy's earnings made like a rocket, taking off 332% last year. The sweetener is that the annual five year growth rate of 19% is also impressive. So I'd be surprised if the P/E ratio was not above average.
Remember: P/E Ratios Don't Consider The Balance Sheet
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.
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).
Is Debt Impacting Origin Energy's P/E?
Origin Energy's net debt equates to 45% of its market capitalization. While that's enough to warrant consideration, it doesn't really concern us.
The Verdict On Origin Energy's P/E Ratio
Origin Energy's P/E is 10.7 which is below average (16.3) in the AU market. The company does have a little debt, and EPS growth was good last year. If it continues to grow, then the current low P/E may prove to be unjustified.
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. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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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.