Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at Pelatro Plc's (LON:PTRO) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, Pelatro has a P/E ratio of 13.68. That corresponds to an earnings yield of approximately 7.3%.
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How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)
Or for Pelatro:
P/E of 13.68 = $1.09 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $0.080 (Based on the year to December 2018.)
Is A High Price-to-Earnings 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.'
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.
In the last year, Pelatro grew EPS like Taylor Swift grew her fan base back in 2010; the 66% gain was both fast and well deserved. The cherry on top is that the five year growth rate was an impressive 100% per year. So I'd be surprised if the P/E ratio was not above average.
Does Pelatro Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Pelatro has a lower P/E than the average (30.3) P/E for companies in the software industry.
This suggests that market participants think Pelatro will underperform other companies in its industry. Since the market seems unimpressed with Pelatro, it's quite possible it could surprise on the upside. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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 Pelatro's Balance Sheet Tell Us?
The extra options and safety that comes with Pelatro's US$1.8m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Bottom Line On Pelatro's P/E Ratio
Pelatro's P/E is 13.7 which is below average (16.2) in the GB market. It grew its EPS nicely over the last year, and the healthy balance sheet implies there is more potential for growth. The relatively low P/E ratio implies the market is pessimistic. Given analysts are expecting further growth, one I would have expected a higher P/E ratio. So this stock may well be worth further research.
Investors should be looking to buy stocks that the market is wrong about. 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 report on the analyst consensus forecasts could help you make a master move on this stock.
You might be able to find a better buy than Pelatro. 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).
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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.