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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 apply a basic P/E ratio analysis to Methanex Corporation's (TSE:MX), to help you decide if the stock is worth further research. Based on the last twelve months, Methanex's P/E ratio is 7.24. That corresponds to an earnings yield of approximately 13.8%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)
Or for Methanex:
P/E of 7.24 = CA$35.21 (Note: this is the share price in the reporting currency, namely, USD ) ÷ CA$4.86 (Based on the year to June 2019.)
Is A High Price-to-Earnings Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. 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 Methanex Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. The image below shows that Methanex has a lower P/E than the average (15.3) P/E for companies in the chemicals industry.
This suggests that market participants think Methanex will underperform other companies in its 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. Earnings growth means that in the future the 'E' will be higher. That means unless the share price increases, the P/E will reduce in a few years. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Methanex increased earnings per share by 7.0% last year. And it has improved its earnings per share by 93% per year over the last three years.
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. In other words, it does not consider any debt or cash that the company may have on the balance sheet. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
Methanex's Balance Sheet
Methanex has net debt equal to 45% of its market cap. While it's worth keeping this in mind, it isn't a worry.
The Bottom Line On Methanex's P/E Ratio
Methanex trades on a P/E ratio of 7.2, which is below the CA market average of 14.1. The company hasn't stretched its balance sheet, and earnings are improving. If you believe growth will continue - or even increase - then the low P/E may signify opportunity.
Investors should be looking to buy stocks that the market is wrong about. 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 report on the analyst consensus forecasts could help you make a master move on this stock.
But note: Methanex 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).
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 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. Thank you for reading.