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Here's How P/E Ratios Can Help Us Understand CF Energy Corp. (CVE:CFY)

Simply Wall St

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at CF Energy Corp.'s (CVE:CFY) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, CF Energy has a P/E ratio of 7.91. That means that at current prices, buyers pay CA$7.91 for every CA$1 in trailing yearly profits.

See our latest analysis for CF Energy

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)

Or for CF Energy:

P/E of 7.91 = CNY3.16 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CNY0.40 (Based on the trailing twelve months to September 2019.)

Is A High P/E Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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 CF Energy Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio indicates whether the market has higher or lower expectations of a company. If you look at the image below, you can see CF Energy has a lower P/E than the average (17.7) in the gas utilities industry classification.

TSXV:CFY Price Estimation Relative to Market, January 24th 2020

This suggests that market participants think CF Energy will underperform other companies in its industry. Many investors like to buy stocks when the market is pessimistic about their prospects. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

CF Energy saw earnings per share decrease by 34% last year. But over the longer term (5 years) earnings per share have increased by 9.4%.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn't take debt or cash into account. 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).

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.

How Does CF Energy's Debt Impact Its P/E Ratio?

CF Energy's net debt equates to 46% of its market capitalization. You'd want to be aware of this fact, but it doesn't bother us.

The Bottom Line On CF Energy's P/E Ratio

CF Energy trades on a P/E ratio of 7.9, which is below the CA market average of 15.9. With only modest debt, it's likely the lack of EPS growth at least partially explains the pessimism implied by the P/E ratio.

When the market is wrong about a stock, it gives savvy investors an opportunity. 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. We don't have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.

But note: CF Energy 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).

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.

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. Thank you for reading.