This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we'll show how Estia Health Limited's (ASX:EHE) P/E ratio could help you assess the value on offer. What is Estia Health's P/E ratio? Well, based on the last twelve months it is 16.22. That means that at current prices, buyers pay A$16.22 for every A$1 in trailing yearly profits.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Estia Health:
P/E of 16.22 = A$2.57 ÷ A$0.16 (Based on the trailing twelve months to June 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 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 Estia Health'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 Estia Health has a lower P/E than the average (17.7) P/E for companies in the healthcare industry.
Its relatively low P/E ratio indicates that Estia Health shareholders think it will struggle to do as well as other companies in its industry classification. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or selling.
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. 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.
Estia Health had pretty flat EPS growth in the last year. But EPS is up 1.5% over the last 3 years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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 Estia Health's Balance Sheet Tell Us?
Net debt totals 17% of Estia Health's market cap. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.
The Bottom Line On Estia Health's P/E Ratio
Estia Health's P/E is 16.2 which is about average (17.2) in the AU market. When you consider the modest EPS growth last year (along with some debt), it seems the market thinks the growth is sustainable.
Investors have an opportunity when market expectations about a stock are wrong. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. 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.
But note: Estia Health 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 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.