This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we'll show how Multi-Chem Limited's (SGX:AWZ) P/E ratio could help you assess the value on offer. Multi-Chem has a P/E ratio of 9.66, based on the last twelve months. That is equivalent to an earnings yield of about 10.4%.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Multi-Chem:
P/E of 9.66 = SGD0.84 ÷ SGD0.09 (Based on the trailing twelve months to December 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each SGD1 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 Does Multi-Chem'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 Multi-Chem has a lower P/E than the average (12.1) in the electronic industry classification.
This suggests that market participants think Multi-Chem will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. 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 unless the share price falls, the P/E will increase in a few years. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
Multi-Chem increased earnings per share by a whopping 41% last year. And its annual EPS growth rate over 5 years is 10%. So we'd generally expect it to have a relatively high P/E ratio. In contrast, EPS has decreased by 7.0%, annually, over 3 years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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 Multi-Chem's P/E?
With net cash of S$36m, Multi-Chem has a very strong balance sheet, which may be important for its business. Having said that, at 46% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Verdict On Multi-Chem's P/E Ratio
Multi-Chem trades on a P/E ratio of 9.7, which is below the SG market average of 13.1. Not only should the net cash position reduce risk, but the recent growth has been impressive. The relatively low P/E ratio implies the market is pessimistic.
Investors have an opportunity when market expectations about a stock are wrong. 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. We don't have analyst forecasts, but you could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than Multi-Chem. 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).
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.
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. Thank you for reading.