Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how Afya Limited's (NASDAQ:AFYA) P/E ratio could help you assess the value on offer. Afya has a price to earnings ratio of 57.17, based on the last twelve months. That corresponds to an earnings yield of approximately 1.7%.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for Afya:
P/E of 57.17 = R$115.828 ÷ R$2.026 (Based on the trailing twelve months to December 2019.)
(Note: the above calculation uses the share price in the reporting currency, namely BRL and the calculation results may not be precise due to rounding.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each R$1 of company earnings. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
Does Afya Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Afya has a significantly higher P/E than the average (17.9) P/E for companies in the consumer services industry.
Its relatively high P/E ratio indicates that Afya shareholders think it will perform better than other companies in its industry classification. Shareholders are clearly optimistic, but the future is always uncertain. So investors should delve deeper. I like to check if company insiders have been buying or selling.
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. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Most would be impressed by Afya earnings growth of 10% in the last year. And earnings per share have improved by 7.5% annually, over the last five years. This could arguably justify a relatively high P/E ratio.
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. That means it doesn't take debt or cash into account. 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).
So What Does Afya's Balance Sheet Tell Us?
The extra options and safety that comes with Afya's R$882m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Verdict On Afya's P/E Ratio
With a P/E ratio of 57.2, Afya is expected to grow earnings very strongly in the years to come. With cash in the bank the company has plenty of growth options -- and it is already on the right track. So it does not seem strange that the P/E is above average.
Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
But note: Afya 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.
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