This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll show how you can use Champion Iron Limited's (ASX:CIA) P/E ratio to inform your assessment of the investment opportunity. Champion Iron has a price to earnings ratio of 9.79, based on the last twelve months. In other words, at today's prices, investors are paying A$9.79 for every A$1 in prior year profit.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for Champion Iron:
P/E of 9.79 = CAD1.80 (Note: this is the share price in the reporting currency, namely, CAD ) ÷ CAD0.18 (Based on the trailing twelve months to December 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each CAD1 of company earnings. 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 Champion Iron's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. We can see in the image below that the average P/E (11.5) for companies in the metals and mining industry is higher than Champion Iron's P/E.
Champion Iron'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. 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
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 unless the share price increases, the P/E will reduce in a few years. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Notably, Champion Iron grew EPS by a whopping 42% in the last year.
Remember: P/E Ratios Don't Consider The Balance Sheet
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 investing in growth. That means taking on debt (or spending its 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).
Champion Iron's Balance Sheet
Net debt totals just 5.4% of Champion Iron's market cap. The market might award it a higher P/E ratio if it had net cash, but its unlikely this low level of net borrowing is having a big impact on the P/E multiple.
The Bottom Line On Champion Iron's P/E Ratio
Champion Iron trades on a P/E ratio of 9.8, which is below the AU market average of 17.8. The EPS growth last year was strong, and debt levels are quite reasonable. The low P/E ratio suggests current market expectations are muted, implying these levels of growth will not continue. Because analysts are predicting more growth in the future, one might have expected to see a higher P/E ratio. You can take a closer look at the fundamentals, here.
Investors should be looking to buy stocks that the market is wrong about. 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.
Of course you might be able to find a better stock than Champion Iron. So you may wish to see this free collection of other companies that have grown earnings strongly.
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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