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Should You Be Tempted To Sell Galp Energia, SGPS, S.A. (ELI:GALP) Because Of Its P/E Ratio?

Simply Wall St

Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use Galp Energia, SGPS, S.A.'s (ELI:GALP) P/E ratio to inform your assessment of the investment opportunity. Looking at earnings over the last twelve months, Galp Energia SGPS has a P/E ratio of 38.66. In other words, at today's prices, investors are paying €38.66 for every €1 in prior year profit.

View our latest analysis for Galp Energia SGPS

How Do You Calculate Galp Energia SGPS's P/E Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Galp Energia SGPS:

P/E of 38.66 = €15.21 ÷ €0.39 (Based on the year to September 2019.)

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 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 Galp Energia SGPS's P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. As you can see below, Galp Energia SGPS has a much higher P/E than the average company (10.2) in the oil and gas industry.

ENXTLS:GALP Price Estimation Relative to Market, November 19th 2019

Galp Energia SGPS's P/E tells us that market participants think the company will perform better than its industry peers, going forward. 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.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. 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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Galp Energia SGPS shrunk earnings per share by 65% over the last year. But it has grown its earnings per share by 23% per year over the last five 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. Thus, the metric does not reflect cash or debt held by the company. 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.

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).

Galp Energia SGPS's Balance Sheet

Net debt totals 13% of Galp Energia SGPS's market cap. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.

The Verdict On Galp Energia SGPS's P/E Ratio

Galp Energia SGPS trades on a P/E ratio of 38.7, which is above its market average of 15.3. With modest debt but no EPS growth in the last year, it's fair to say the P/E implies some optimism about future earnings, from the market.

When the market is wrong about a stock, it gives savvy investors an opportunity. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free report on the analyst consensus forecasts could help you make a master move on this stock.

But note: Galp Energia SGPS 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 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. Thank you for reading.