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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 Profire Energy, Inc.’s (NASDAQ:PFIE) P/E ratio could help you assess the value on offer. Profire Energy has a P/E ratio of 12.09, based on the last twelve months. That corresponds to an earnings yield of approximately 8.3%.
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 Profire Energy:
P/E of 12.09 = $1.64 ÷ $0.14 (Based on the year to September 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each $1 the company has earned over the last year. 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
Earnings growth rates have a big influence on P/E ratios. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Profire Energy increased earnings per share by a whopping 82% last year. And it has improved its earnings per share by 85% per year over the last three years. So we’d generally expect it to have a relatively high P/E ratio. Unfortunately, earnings per share are down 6.6% a year, over 5 years.
How Does Profire Energy’s P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Profire Energy has a P/E ratio that is roughly in line with the energy services industry average (12.4).
Profire Energy’s P/E tells us that market participants think its prospects are roughly in line with its industry. So if Profire Energy 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
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.
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
How Does Profire Energy’s Debt Impact Its P/E Ratio?
Since Profire Energy holds net cash of US$14m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Profire Energy’s P/E Ratio
Profire Energy trades on a P/E ratio of 12.1, which is below the US market average of 16.8. 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. Since analysts are predicting growth will continue, one might expect to see a higher P/E so it may be worth looking closer.
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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
But note: Profire Energy 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).
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.