This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll look at Lovisa Holdings Limited's (ASX:LOV) P/E ratio and reflect on what it tells us about the company's share price. What is Lovisa Holdings's P/E ratio? Well, based on the last twelve months it is 32.75. That means that at current prices, buyers pay A$32.75 for every A$1 in trailing yearly profits.
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 Lovisa Holdings:
P/E of 32.75 = A$11.39 ÷ A$0.35 (Based on the year to December 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each A$1 the company has earned over the last year. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.'
Does Lovisa Holdings Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Lovisa Holdings has a higher P/E than the average (12.6) P/E for companies in the specialty retail industry.
Lovisa Holdings's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn't guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. 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.
Lovisa Holdings increased earnings per share by 8.7% last year. And its annual EPS growth rate over 5 years is 51%.
Remember: P/E Ratios Don't Consider The Balance Sheet
Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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.
How Does Lovisa Holdings's Debt Impact Its P/E Ratio?
Lovisa Holdings has net cash of AU$32m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Verdict On Lovisa Holdings's P/E Ratio
Lovisa Holdings's P/E is 32.7 which is above average (15.8) in its market. Recent earnings growth wasn't bad. And the healthy balance sheet means the company can sustain growth while the P/E suggests shareholders think it will.
Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
But note: Lovisa Holdings 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 email@example.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.