This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll look at MotorCycle Holdings Limited's (ASX:MTO) P/E ratio and reflect on what it tells us about the company's share price. Based on the last twelve months, MotorCycle Holdings's P/E ratio is 11.22. That is equivalent to an earnings yield of about 8.9%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for MotorCycle Holdings:
P/E of 11.22 = A$1.82 ÷ A$0.16 (Based on the trailing twelve months to December 2018.)
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 MotorCycle Holdings 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 MotorCycle Holdings has a lower P/E than the average (13.3) P/E for companies in the specialty retail industry.
MotorCycle Holdings's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Many investors like to buy stocks when the market is pessimistic about their prospects. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. Earnings growth means that in the future the 'E' will be higher. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
MotorCycle Holdings shrunk earnings per share by 13% over the last year. But it has grown its earnings per share by 2.8% per year over the last three years. And EPS is down 13% a year, over the last 5 years. This could justify a pessimistic P/E.
Remember: P/E Ratios Don't Consider The Balance Sheet
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. In other words, it does not consider any debt or cash that the company may have on the balance sheet. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
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 MotorCycle Holdings's Debt Impact Its P/E Ratio?
Net debt totals 68% of MotorCycle Holdings's market cap. This is enough debt that you'd have to make some adjustments before using the P/E ratio to compare it to a company with net cash.
The Verdict On MotorCycle Holdings's P/E Ratio
MotorCycle Holdings has a P/E of 11.2. That's below the average in the AU market, which is 16.4. When you consider that the company has significant debt, and didn't grow EPS last year, it isn't surprising that the market has muted expectations.
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 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 be able to find a better stock than MotorCycle Holdings. 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 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.