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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We’ll show how you can use Electrocomponents plc’s (LON:ECM) P/E ratio to inform your assessment of the investment opportunity. Electrocomponents has a P/E ratio of 15.37, based on the last twelve months. That is equivalent to an earnings yield of about 6.5%.
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 Electrocomponents:
P/E of 15.37 = £5.75 ÷ £0.37 (Based on the year to September 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each £1 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 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. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.
Electrocomponents increased earnings per share by a whopping 54% last year. And its annual EPS growth rate over 5 years is 20%. With that performance, I would expect it to have an above average P/E ratio.
How Does Electrocomponents’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Electrocomponents has a lower P/E than the average (16.6) P/E for companies in the electronic industry.
Its relatively low P/E ratio indicates that Electrocomponents shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Electrocomponents, it’s quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. Thus, the metric does not reflect cash or debt held by the company. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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).
Electrocomponents’s Balance Sheet
Net debt totals just 5.5% of Electrocomponents’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 Verdict On Electrocomponents’s P/E Ratio
Electrocomponents trades on a P/E ratio of 15.4, which is fairly close to the GB market average of 15.9. With only modest debt levels, and strong earnings growth, the market seems to doubt that the growth can be maintained.
Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. 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.
You might be able to find a better buy than Electrocomponents. 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).
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. On rare occasion, data errors may occur. Thank you for reading.