Should You Be Tempted To Sell Pennon Group Plc (LON:PNN) Because Of Its P/E Ratio?
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 Pennon Group Plc's (LON:PNN) P/E ratio to inform your assessment of the investment opportunity. Pennon Group has a P/E ratio of 20.38, based on the last twelve months. That corresponds to an earnings yield of approximately 4.9%.
View our latest analysis for Pennon Group
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 Pennon Group:
P/E of 20.38 = £11.325 ÷ £0.556 (Based on the year to September 2019.)
(Note: the above calculation results may not be precise due to rounding.)
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. 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'.
How Does Pennon Group's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Pennon Group has a higher P/E than the average (17.8) P/E for companies in the water utilities industry.
Its relatively high P/E ratio indicates that Pennon 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 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
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. And in that case, the P/E ratio itself will drop rather quickly. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Pennon Group saw earnings per share improve by -7.3% last year. And it has bolstered its earnings per share by 17% per year over the last five years.
Remember: P/E Ratios Don't Consider The Balance Sheet
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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.
So What Does Pennon Group's Balance Sheet Tell Us?
Pennon Group's net debt equates to 38% of its market capitalization. While that's enough to warrant consideration, it doesn't really concern us.
The Verdict On Pennon Group's P/E Ratio
Pennon Group trades on a P/E ratio of 20.4, which is above its market average of 15.9. With modest debt relative to its size, and modest earnings growth, the market is likely expecting sustained long-term growth, if not a near-term improvement.
Investors have an opportunity when market expectations about a stock are wrong. 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.
Of course you might be able to find a better stock than Pennon Group. So you may wish to see this free collection of other companies that have grown earnings strongly.
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.
