This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we'll show how Gale Pacific Limited's (ASX:GAP) P/E ratio could help you assess the value on offer. What is Gale Pacific's P/E ratio? Well, based on the last twelve months it is 6.08. That corresponds to an earnings yield of approximately 16.4%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Gale Pacific:
P/E of 6.08 = AUD0.20 ÷ AUD0.03 (Based on the trailing twelve months to June 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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 Gale Pacific Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. If you look at the image below, you can see Gale Pacific has a lower P/E than the average (12.7) in the consumer durables industry classification.
Its relatively low P/E ratio indicates that Gale Pacific shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Gale Pacific, it's quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. Then, a higher P/E might scare off shareholders, pushing the share price down.
Gale Pacific's earnings per share fell by 4.2% in the last twelve months. But EPS is up 3.0% over the last 5 years. And EPS is down 2.3% a year, over the last 3 years. So we might expect a relatively low P/E.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. Thus, the metric does not reflect cash or debt held by the company. 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).
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).
Gale Pacific's Balance Sheet
Gale Pacific's net debt is 20% of its market cap. That's enough debt to impact the P/E ratio a little; so keep it in mind if you're comparing it to companies without debt.
The Bottom Line On Gale Pacific's P/E Ratio
Gale Pacific trades on a P/E ratio of 6.1, which is below the AU market average of 18.7. Since it only carries a modest debt load, it's likely the low expectations implied by the P/E ratio arise from the lack of recent earnings growth.
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 you could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than Gale Pacific. 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).
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.
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