This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to The Colonial Motor Company Limited's (NZSE:CMO), to help you decide if the stock is worth further research. Looking at earnings over the last twelve months, Colonial Motor has a P/E ratio of 13.40. That corresponds to an earnings yield of approximately 7.5%.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Colonial Motor:
P/E of 13.40 = NZ$8.98 ÷ NZ$0.67 (Based on the year to June 2019.)
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. 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 Colonial Motor 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. You can see in the image below that the average P/E (12.9) for companies in the specialty retail industry is roughly the same as Colonial Motor's P/E.
Its P/E ratio suggests that Colonial Motor shareholders think that in the future it will perform about the same as other companies in its industry classification. If the company has better than average prospects, then the market might be underestimating it. I would further inform my view by checking insider buying and selling., among other things.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the 'E' will be higher. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.
Colonial Motor saw earnings per share decrease by 12% last year. But over the longer term (5 years) earnings per share have increased by 2.7%.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
The 'Price' in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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 Colonial Motor's Debt Impact Its P/E Ratio?
Colonial Motor's net debt equates to 39% of its market capitalization. While that's enough to warrant consideration, it doesn't really concern us.
The Bottom Line On Colonial Motor's P/E Ratio
Colonial Motor has a P/E of 13.4. That's below the average in the NZ market, which is 18.7. With only modest debt, it's likely the lack of EPS growth at least partially explains the pessimism implied by the P/E ratio.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. 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.
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 email@example.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.