This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll show how you can use The Go-Ahead Group plc's (LON:GOG) P/E ratio to inform your assessment of the investment opportunity. Go-Ahead Group has a price to earnings ratio of 12.21, based on the last twelve months. That corresponds to an earnings yield of approximately 8.2%.
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 Go-Ahead Group:
P/E of 12.21 = £18.61 ÷ £1.52 (Based on the trailing twelve months 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 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
If earnings fall then in the future the 'E' will be lower. That means even if the current P/E is low, it will increase over time if the share price stays flat. Then, a higher P/E might scare off shareholders, pushing the share price down.
Go-Ahead Group saw earnings per share decrease by 29% last year. But it has grown its earnings per share by 2.8% per year over the last five years. And EPS is down 2.6% a year, over the last 3 years. This might lead to low expectations.
Does Go-Ahead Group Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. You can see in the image below that the average P/E (10.5) for companies in the transportation industry is lower than Go-Ahead Group's P/E.
Its relatively high P/E ratio indicates that Go-Ahead Group shareholders think it will perform better than other companies in its industry classification. Shareholders are clearly optimistic, but the future is always uncertain. So investors should delve deeper. I like to check if company insiders have been buying or selling.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
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.
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
Go-Ahead Group's Balance Sheet
With net cash of UK£202m, Go-Ahead Group has a very strong balance sheet, which may be important for its business. Having said that, at 25% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On Go-Ahead Group's P/E Ratio
Go-Ahead Group has a P/E of 12.2. That's below the average in the GB market, which is 16.2. The recent drop in earnings per share would make investors cautious, but the net cash position means the company has time to improve: if so, the low P/E could be an 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 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 Go-Ahead Group. 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).
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.