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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Newport Exploration Ltd.'s (CVE:NWX), to help you decide if the stock is worth further research. Newport Exploration has a P/E ratio of 8.18, based on the last twelve months. That means that at current prices, buyers pay CA$8.18 for every CA$1 in trailing yearly profits.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Newport Exploration:
P/E of 8.18 = CA$0.30 ÷ CA$0.037 (Based on the trailing twelve months to April 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 CA$1 the company has earned over the last year. 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.
How Does Newport Exploration's P/E Ratio Compare To Its Peers?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. The image below shows that Newport Exploration has a lower P/E than the average (16.3) P/E for companies in the metals and mining industry.
Newport Exploration's P/E tells us that market participants think it will not fare as well as its peers in the same industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
How Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Newport Exploration had pretty flat EPS growth in the last year. But over the longer term (3 years), earnings per share have increased by 116%. And it has shrunk its earnings per share by 24% per year over the last five years. So it would be surprising to see a high P/E.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
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. 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 spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
So What Does Newport Exploration's Balance Sheet Tell Us?
Newport Exploration has net cash of CA$6.7m. This is fairly high at 21% of its market capitalization. That might mean balance sheet strength is important to the business, but should also help push the P/E a bit higher than it would otherwise be.
The Bottom Line On Newport Exploration's P/E Ratio
Newport Exploration trades on a P/E ratio of 8.2, which is below the CA market average of 15.1. Earnings improved over the last year. And the net cash position gives the company many options. So it's strange that the low P/E indicates low expectations.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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.' Although we don't have analyst forecasts, shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than Newport Exploration. 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.