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 Storm Resources Ltd.'s (TSE:SRX), to help you decide if the stock is worth further research. Storm Resources has a P/E ratio of 6.86, based on the last twelve months. That is equivalent to an earnings yield of about 15%.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Storm Resources:
P/E of 6.86 = CA$2.26 ÷ CA$0.33 (Based on the trailing twelve months to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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
P/E ratios primarily reflect market expectations around earnings growth rates. When earnings grow, the 'E' increases, over time. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Storm Resources maintained roughly steady earnings over the last twelve months.
Does Storm Resources Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. We can see in the image below that the average P/E (15.3) for companies in the oil and gas industry is higher than Storm Resources's P/E.
Storm Resources's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Since the market seems unimpressed with Storm Resources, 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
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. 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.
So What Does Storm Resources's Balance Sheet Tell Us?
Storm Resources has net debt equal to 32% of its market cap. While it's worth keeping this in mind, it isn't a worry.
The Bottom Line On Storm Resources's P/E Ratio
Storm Resources trades on a P/E ratio of 6.9, which is below the CA market average of 15.1. The company hasn't stretched its balance sheet, and earnings are improving. If growth is sustainable over the long term, then the current P/E ratio may be a sign of good value.
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 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 Storm Resources. 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. Thank you for reading.