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 McMillan Shakespeare Limited's (ASX:MMS) P/E ratio could help you assess the value on offer. McMillan Shakespeare has a price to earnings ratio of 17.40, based on the last twelve months. That is equivalent to an earnings yield of about 5.7%.
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 McMillan Shakespeare:
P/E of 17.40 = A$13.40 ÷ A$0.77 (Based on the year to June 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. That isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
Does McMillan Shakespeare 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. If you look at the image below, you can see McMillan Shakespeare has a lower P/E than the average (20.2) in the professional services industry classification.
McMillan Shakespeare's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Since the market seems unimpressed with McMillan Shakespeare, it's quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
When earnings fall, the 'E' decreases, over time. That means even if the current P/E is low, it will increase over time if the share price stays flat. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.
It's nice to see that McMillan Shakespeare grew EPS by a stonking 26% in the last year. In contrast, EPS has decreased by 8.2%, annually, over 3 years.
Remember: P/E Ratios Don't Consider The Balance Sheet
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).
While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
Is Debt Impacting McMillan Shakespeare's P/E?
McMillan Shakespeare has net debt worth 19% of its market capitalization. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.
The Bottom Line On McMillan Shakespeare's P/E Ratio
McMillan Shakespeare trades on a P/E ratio of 17.4, which is fairly close to the AU market average of 18.8. 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. Given analysts are expecting further growth, one might have expected a higher P/E ratio. That may be worth further research.
Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine. 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.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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.
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