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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 TransAlta Renewables Inc.'s (TSE:RNW) P/E ratio could help you assess the value on offer. TransAlta Renewables has a P/E ratio of 14.79, based on the last twelve months. In other words, at today's prices, investors are paying CA$14.79 for every CA$1 in prior year profit.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for TransAlta Renewables:
P/E of 14.79 = CA$13.97 ÷ CA$0.94 (Based on the trailing twelve months to March 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each CA$1 of company 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 Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
In the last year, TransAlta Renewables grew EPS like Taylor Swift grew her fan base back in 2010; the 375% gain was both fast and well deserved. Having said that, if we look back three years, EPS growth has averaged a comparatively less impressive 9.2%.
Does TransAlta Renewables 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. You can see in the image below that the average P/E (13.7) for companies in the renewable energy industry is lower than TransAlta Renewables's P/E.
That means that the market expects TransAlta Renewables will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So further research is always essential. I often monitor director buying and selling.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
The 'Price' in P/E reflects the market capitalization of the company. 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).
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.
How Does TransAlta Renewables's Debt Impact Its P/E Ratio?
TransAlta Renewables has net debt worth 24% of its market capitalization. That's enough debt to impact the P/E ratio a little; so keep it in mind if you're comparing it to companies without debt.
The Verdict On TransAlta Renewables's P/E Ratio
TransAlta Renewables trades on a P/E ratio of 14.8, which is fairly close to the CA market average of 15.1. Given it has reasonable debt levels, and grew earnings strongly last year, the P/E indicates the market has doubts this growth can be sustained.
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. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
Of course you might be able to find a better stock than TransAlta Renewables. 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.