The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll show how you can use MGP Ingredients, Inc.'s (NASDAQ:MGPI) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, MGP Ingredients's P/E ratio is 29.11. In other words, at today's prices, investors are paying $29.11 for every $1 in prior year profit.
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How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for MGP Ingredients:
P/E of 29.11 = $64.56 ÷ $2.22 (Based on the year to March 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each $1 the company has earned over the last year. 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
Earnings growth rates have a big influence on P/E ratios. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means unless the share price increases, the P/E will reduce in a few years. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
MGP Ingredients saw earnings per share decrease by 9.6% last year. But EPS is up 11% over the last 3 years.
Does MGP Ingredients Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. The image below shows that MGP Ingredients has a P/E ratio that is roughly in line with the beverage industry average (29.4).
That indicates that the market expects MGP Ingredients will perform roughly in line with other companies in its industry. So if MGP Ingredients actually outperforms its peers going forward, that should be a positive for the share price. I inform my view byby checking management tenure and remuneration, among other things.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. So it won't reflect the advantage of cash, or disadvantage of debt. 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.
MGP Ingredients's Balance Sheet
MGP Ingredients's net debt is 4.1% of its market cap. The market might award it a higher P/E ratio if it had net cash, but its unlikely this low level of net borrowing is having a big impact on the P/E multiple.
The Verdict On MGP Ingredients's P/E Ratio
MGP Ingredients has a P/E of 29.1. That's higher than the average in the US market, which is 17.7. With modest debt but no EPS growth in the last year, it's fair to say the P/E implies some optimism about future earnings, from the market.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. 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.
You might be able to find a better buy than MGP Ingredients. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
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 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.