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 New Hope Corporation Limited's (ASX:NHC) P/E ratio could help you assess the value on offer. New Hope has a price to earnings ratio of 14.29, based on the last twelve months. That corresponds to an earnings yield of approximately 7.0%.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for New Hope:
P/E of 14.29 = A$2.56 ÷ A$0.18 (Based on the trailing twelve months to January 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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 New Hope 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. As you can see below, New Hope has a higher P/E than the average company (8) in the oil and gas industry.
That means that the market expects New Hope will outperform other companies in its industry. Shareholders are clearly optimistic, but the future is always uncertain. 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
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. 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.
New Hope saw earnings per share decrease by 23% last year. But EPS is up 40% over the last 5 years.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won't reflect the advantage of cash, or disadvantage of debt. 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).
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).
New Hope's Balance Sheet
New Hope's net debt is 4.9% of its market cap. It would probably trade on a higher P/E ratio if it had a lot of cash, but I doubt it is having a big impact.
The Bottom Line On New Hope's P/E Ratio
New Hope trades on a P/E ratio of 14.3, which is below the AU market average of 16.3. The debt levels are not a major concern, but the lack of EPS growth is likely weighing on sentiment.
When the market is wrong about a stock, it gives savvy investors an opportunity. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course you might be able to find a better stock than New Hope. So you may wish to see this free collection of other companies that have grown earnings strongly.
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.