This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Wajax Corporation’s (TSE:WJX) P/E ratio could help you assess the value on offer. Wajax has a P/E ratio of 9.23, based on the last twelve months. That is equivalent to an earnings yield of about 11%.
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 Wajax:
P/E of 9.23 = CA$19.08 ÷ CA$2.07 (Based on the trailing twelve months to September 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.
Wajax increased earnings per share by a whopping 28% last year. And its annual EPS growth rate over 3 years is 64%. So we’d generally expect it to have a relatively high P/E ratio. In contrast, EPS has decreased by 16%, annually, over 5 years.
How Does Wajax’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Wajax has a P/E ratio that is roughly in line with the trade distributors industry average (9.8).
Wajax’s P/E tells us that market participants think its prospects are roughly in line with its industry. So if Wajax actually outperforms its peers going forward, that should be a positive for the share price. I inform my view byby checking management tenure and remuneration, among other things.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The ‘Price’ in P/E reflects the market capitalization of the company. 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 taking on debt (or spending its remaining cash).
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).
Is Debt Impacting Wajax’s P/E?
Wajax has net debt worth 52% of its market capitalization. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.
The Verdict On Wajax’s P/E Ratio
Wajax has a P/E of 9.2. That’s below the average in the CA market, which is 14.7. The company may have significant debt, but EPS growth was good last year. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.
Investors have an opportunity when market expectations about a stock are wrong. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course you might be able to find a better stock than Wajax. 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 firstname.lastname@example.org. 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.