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 Collins Foods Limited's (ASX:CKF) P/E ratio could help you assess the value on offer. Based on the last twelve months, Collins Foods's P/E ratio is 30.47. In other words, at today's prices, investors are paying A$30.47 for every A$1 in prior year profit.
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 Collins Foods:
P/E of 30.47 = A$10.23 ÷ A$0.34 (Based on the trailing twelve months to April 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 A$1 the company has earned over the last year. 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.
How Does Collins Foods's P/E Ratio Compare To Its Peers?
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 (23.5) for companies in the hospitality industry is lower than Collins Foods's P/E.
Collins Foods'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 further research is always essential. I often monitor director buying and selling.
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. That means unless the share price increases, the P/E will reduce in a few years. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
It's great to see that Collins Foods grew EPS by 19% in the last year. And earnings per share have improved by 17% annually, over the last five years. So one might expect an above average P/E ratio.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
Don't forget that the P/E ratio considers market capitalization. That means it doesn't take debt or cash into account. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
Is Debt Impacting Collins Foods's P/E?
Collins Foods's net debt is 18% of its market cap. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.
The Bottom Line On Collins Foods's P/E Ratio
Collins Foods trades on a P/E ratio of 30.5, which is above its market average of 18.2. The company is not overly constrained by its modest debt levels, and its recent EPS growth very solid. So on this analysis it seems reasonable that its P/E ratio is above average.
Investors should be looking to buy stocks that the market is wrong about. 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.
But note: Collins Foods 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).
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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. Thank you for reading.