The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how Norish Plc's (LON:NSH) P/E ratio could help you assess the value on offer. Norish has a P/E ratio of 11.81, based on the last twelve months. That corresponds to an earnings yield of approximately 8.5%.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Norish:
P/E of 11.81 = £0.59 ÷ £0.050 (Based on the year to December 2018.)
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.
How Does Norish's P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. If you look at the image below, you can see Norish has a lower P/E than the average (18.8) in the commercial services industry classification.
This suggests that market participants think Norish 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. You should delve deeper. I like to check if company insiders have been buying or 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. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
It's great to see that Norish grew EPS by 23% in the last year. And its annual EPS growth rate over 3 years is 20%. This could arguably justify a relatively high P/E ratio. In contrast, EPS has decreased by 9.8%, annually, over 5 years.
Remember: P/E Ratios Don't Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won't reflect the advantage of cash, or disadvantage of debt. 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).
Is Debt Impacting Norish's P/E?
Norish has net debt equal to 26% of its market cap. You'd want to be aware of this fact, but it doesn't bother us.
The Verdict On Norish's P/E Ratio
Norish has a P/E of 11.8. That's below the average in the GB market, which is 15.8. 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. Given analysts are expecting further growth, one might have expected a higher P/E ratio. That may be worth further research.
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.
But note: Norish 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).
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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.