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Here's What ARB Corporation Limited's (ASX:ARB) P/E Is Telling Us

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Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use ARB Corporation Limited's (ASX:ARB) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, ARB's P/E ratio is 27.07. That corresponds to an earnings yield of approximately 3.7%.

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Price per Share Ã· Earnings per Share (EPS)

Or for ARB:

P/E of 27.07 = A\$18.71 Ã· A\$0.69 (Based on the year to December 2018.)

Is A High Price-to-Earnings Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing 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.

How Does ARB's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. The image below shows that ARB has a higher P/E than the average (13.1) P/E for companies in the auto components industry.

That means that the market expects ARB will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So further research is always essential. I often monitor director buying and selling.

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. 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. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

Most would be impressed by ARB earnings growth of 11% in the last year. And earnings per share have improved by 3.8% annually, over the last five years. With that performance, you might expect an above average P/E ratio.

Remember: P/E Ratios Don't Consider The Balance Sheet

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).

Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.

So What Does ARB's Balance Sheet Tell Us?

Since ARB holds net cash of AU\$5.2m, it can spend on growth, justifying a higher P/E ratio than otherwise.

The Bottom Line On ARB's P/E Ratio

ARB has a P/E of 27.1. That's higher than the average in its market, which is 16.1. Its strong balance sheet gives the company plenty of resources for extra growth, and it has already proven it can grow. So it is not surprising the market is probably extrapolating recent growth well into the future, reflected in the relatively high P/E ratio.

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. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

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.

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 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. Thank you for reading.