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Is Evolution Petroleum Corporation's (NYSEMKT:EPM) High P/E Ratio A Problem For Investors?

Simply Wall St

The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll show how you can use Evolution Petroleum Corporation's (NYSEMKT:EPM) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Evolution Petroleum's P/E ratio is 13.96. In other words, at today's prices, investors are paying $13.96 for every $1 in prior year profit.

View our latest analysis for Evolution Petroleum

How Do I Calculate A Price To Earnings Ratio?

The formula for P/E is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Evolution Petroleum:

P/E of 13.96 = USD5.21 ÷ USD0.37 (Based on the year to September 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each USD1 the company has earned over the last year. 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'.

Does Evolution Petroleum 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. You can see in the image below that the average P/E (10.2) for companies in the oil and gas industry is lower than Evolution Petroleum's P/E.

AMEX:EPM Price Estimation Relative to Market, January 15th 2020

That means that the market expects Evolution Petroleum 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.

How Growth Rates Impact P/E Ratios

Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. 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.

Evolution Petroleum saw earnings per share decrease by 47% last year. But EPS is up 36% over the last 5 years. And over the longer term (3 years) earnings per share have decreased 17% annually. This might lead to low expectations.

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. 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).

How Does Evolution Petroleum's Debt Impact Its P/E Ratio?

With net cash of US$31m, Evolution Petroleum has a very strong balance sheet, which may be important for its business. Having said that, at 18% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Verdict On Evolution Petroleum's P/E Ratio

Evolution Petroleum trades on a P/E ratio of 14.0, which is below the US market average of 18.9. Falling earnings per share are likely to be keeping potential buyers away, but the net cash position means the company has time to improve: if so, the low P/E could be an opportunity.

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 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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.

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.