Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how Collection House Limited's (ASX:CLH) P/E ratio could help you assess the value on offer. What is Collection House's P/E ratio? Well, based on the last twelve months it is 5.43. That is equivalent to an earnings yield of about 18.4%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Collection House:
P/E of 5.43 = A$1.21 ÷ A$0.22 (Based on the year to June 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each A$1 the company has earned over the last year. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.
Does Collection House Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. If you look at the image below, you can see Collection House has a lower P/E than the average (12.6) in the consumer finance industry classification.
Its relatively low P/E ratio indicates that Collection House shareholders think it will struggle to do as well as other companies in its industry classification. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. When earnings grow, the 'E' increases, over time. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Most would be impressed by Collection House earnings growth of 16% in the last year. And earnings per share have improved by 8.7% annually, over the last five years. With that performance, you might expect an above average P/E ratio.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
Don't forget that the P/E ratio considers market capitalization. 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).
So What Does Collection House's Balance Sheet Tell Us?
Net debt totals 91% of Collection House's market cap. This is a reasonably significant level of debt -- all else being equal you'd expect a much lower P/E than if it had net cash.
The Verdict On Collection House's P/E Ratio
Collection House's P/E is 5.4 which is below average (18.3) in the AU market. While the EPS growth last year was strong, the significant debt levels reduce the number of options available to management. If it continues to grow, then the current low P/E may prove to be unjustified.
Investors should be looking to buy stocks that the market is wrong about. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. 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 Collection House. 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 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.