The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at Ricardo plc's (LON:RCDO) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, Ricardo has a P/E ratio of 19.69. That means that at current prices, buyers pay £19.69 for every £1 in trailing yearly profits.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Ricardo:
P/E of 19.69 = £7.30 ÷ £0.37 (Based on the year to June 2019.)
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. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
Does Ricardo 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 Ricardo has a lower P/E than the average (21.4) P/E for companies in the professional services industry.
Its relatively low P/E ratio indicates that Ricardo shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Ricardo, it's quite possible it could surprise on the upside. 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
If earnings fall then in the future the 'E' will be lower. 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.
It's great to see that Ricardo grew EPS by 13% in the last year. In contrast, EPS has decreased by 8.6%, 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. That means it doesn't take debt or cash into account. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
So What Does Ricardo's Balance Sheet Tell Us?
Ricardo's net debt is 12% of its market cap. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.
The Verdict On Ricardo's P/E Ratio
Ricardo trades on a P/E ratio of 19.7, which is above its market average of 17.2. Its debt levels do not imperil its balance sheet and it is growing EPS strongly. So on this analysis it seems reasonable that its P/E ratio is above average.
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. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
But note: Ricardo may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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.
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