The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how St Barbara Limited's (ASX:SBM) P/E ratio could help you assess the value on offer. St Barbara has a price to earnings ratio of 9.97, based on the last twelve months. That is equivalent to an earnings yield of about 10.0%.
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 St Barbara:
P/E of 9.97 = A$2.69 ÷ A$0.27 (Based on the trailing twelve months to June 2019.)
Is A High P/E Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. 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 St Barbara's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. If you look at the image below, you can see St Barbara has a lower P/E than the average (12.9) in the metals and mining industry classification.
Its relatively low P/E ratio indicates that St Barbara shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with St Barbara, it's quite possible it could surprise on the upside. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means even if the current P/E is low, it will increase over time if the share price stays flat. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
St Barbara shrunk earnings per share by 39% over the last year. And it has shrunk its earnings per share by 7.6% per year over the last three years. This might lead to low expectations.
Remember: P/E Ratios Don't Consider The Balance Sheet
The 'Price' in P/E reflects the market capitalization of the company. That means it doesn't take debt or cash into account. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
So What Does St Barbara's Balance Sheet Tell Us?
With net cash of AU$890m, St Barbara has a very strong balance sheet, which may be important for its business. Having said that, at 47% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On St Barbara's P/E Ratio
St Barbara's P/E is 10.0 which is below average (18.4) in the AU market. The recent drop in earnings per share would almost certainly temper expectations, the relatively strong balance sheet will allow the company time to invest in growth. If it achieves that, then there's real potential that the low P/E could eventually indicate undervaluation.
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 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 St Barbara. 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.