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 Eurogerm SA's (EPA:ALGEM) P/E ratio could help you assess the value on offer. Eurogerm has a price to earnings ratio of 18.98, based on the last twelve months. That corresponds to an earnings yield of approximately 5.3%.
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 Eurogerm:
P/E of 18.98 = €29.80 ÷ €1.57 (Based on the year to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each €1 the company has earned over the last year. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.
Does Eurogerm Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. You can see in the image below that the average P/E (16.6) for companies in the food industry is lower than Eurogerm's P/E.
Its relatively high P/E ratio indicates that Eurogerm shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. When earnings grow, the 'E' increases, over time. And in that case, the P/E ratio itself will drop rather quickly. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Eurogerm's earnings per share grew by -5.4% in the last twelve months. And earnings per share have improved by 19% annually, over the last five years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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.
How Does Eurogerm's Debt Impact Its P/E Ratio?
Eurogerm has net cash of €11m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Verdict On Eurogerm's P/E Ratio
Eurogerm trades on a P/E ratio of 19.0, which is above its market average of 17.5. Earnings improved over the last year. And the net cash position provides the company with multiple options. The high P/E suggests the market thinks further growth will come.
Investors have an opportunity when market expectations about a stock are wrong. 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 report on the analyst consensus forecasts could help you make a master move on this stock.
You might be able to find a better buy than Eurogerm. 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).
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 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.