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A Rising Share Price Has Us Looking Closely At Energy One Limited's (ASX:EOL) P/E Ratio

Simply Wall St

Energy One (ASX:EOL) shares have had a really impressive month, gaining 34%, after some slippage. Zooming out, the annual gain of 163% knocks our socks off.

All else being equal, a sharp share price increase should make a stock less attractive to potential investors. While the market sentiment towards a stock is very changeable, in the long run, the share price will tend to move in the same direction as earnings per share. So some would prefer to hold off buying when there is a lot of optimism towards a stock. Perhaps the simplest way to get a read on investors' expectations of a business is to look at its Price to Earnings Ratio (PE Ratio). A high P/E ratio means that investors have a high expectation about future growth, while a low P/E ratio means they have low expectations about future growth.

See our latest analysis for Energy One

How Does Energy One's P/E Ratio Compare To Its Peers?

We can tell from its P/E ratio of 49.02 that there is some investor optimism about Energy One. You can see in the image below that the average P/E (37.8) for companies in the software industry is lower than Energy One's P/E.

ASX:EOL Price Estimation Relative to Market, January 17th 2020

Its relatively high P/E ratio indicates that Energy One shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn't guarantee future growth. So further research is always essential. I often monitor director buying and 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 Energy One earnings growth of 21% in the last year. And it has bolstered its earnings per share by 27% per year over the last five years. This could arguably justify a relatively high P/E ratio.

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. That means it doesn't take debt or cash into account. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

Energy One's Balance Sheet

Net debt totals just 6.3% of Energy One's market cap. So it doesn't have as many options as it would with net cash, but its debt would not have much of an impact on its P/E ratio.

The Verdict On Energy One's P/E Ratio

Energy One trades on a P/E ratio of 49.0, which is above its market average of 19.2. While the company does use modest debt, its recent earnings growth is very good. Therefore, it's not particularly surprising that it has a above average P/E ratio. What is very clear is that the market has become significantly more optimistic about Energy One over the last month, with the P/E ratio rising from 36.5 back then to 49.0 today. For those who prefer to invest with the flow of momentum, that might mean it's time to put the stock on a watchlist, or research it. But the contrarian may see it as a missed opportunity.

Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. We don't have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.

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. Thank you for reading.