This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we'll show how MJ Gleeson plc's (LON:GLE) P/E ratio could help you assess the value on offer. Based on the last twelve months, MJ Gleeson's P/E ratio is 15.53. That means that at current prices, buyers pay £15.53 for every £1 in trailing yearly profits.
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 MJ Gleeson:
P/E of 15.53 = £9.55 ÷ £0.62 (Based on the year to June 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each £1 of company earnings. 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 MJ Gleeson Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. The image below shows that MJ Gleeson has a higher P/E than the average (11.9) P/E for companies in the consumer durables industry.
MJ Gleeson'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
P/E ratios primarily reflect market expectations around earnings growth rates. 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.
MJ Gleeson's earnings per share grew by -9.8% in the last twelve months. And earnings per share have improved by 13% annually, over the last five years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. That means it doesn't take debt or cash into account. 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.
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.
MJ Gleeson's Balance Sheet
Since MJ Gleeson holds net cash of UK£30m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On MJ Gleeson's P/E Ratio
MJ Gleeson has a P/E of 15.5. That's below the average in the GB market, which is 18.3. Earnings improved over the last year. And the healthy balance sheet means the company can sustain growth while the P/E suggests shareholders don't think it will.
Investors should be looking to buy stocks that the market is wrong about. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. 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.
But note: MJ Gleeson 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).
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.
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.