Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how Tennant Company's (NYSE:TNC) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, Tennant has a P/E ratio of 32.76. In other words, at today's prices, investors are paying $32.76 for every $1 in prior year profit.
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 Tennant:
P/E of 32.76 = $68.32 ÷ $2.09 (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.'
How Does Tennant's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Tennant has a higher P/E than the average (19.8) P/E for companies in the machinery industry.
That means that the market expects Tennant will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. 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. 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. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Tennant's 127% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. Having said that, if we look back three years, EPS growth has averaged a comparatively less impressive 4.8%. Unfortunately, earnings per share are down 2.0% a year, over 5 years.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
The 'Price' in P/E reflects the market capitalization of the company. 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.
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.
How Does Tennant's Debt Impact Its P/E Ratio?
Net debt totals 24% of Tennant's market cap. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.
The Verdict On Tennant's P/E Ratio
Tennant trades on a P/E ratio of 32.8, which is above its market average of 17.4. The company is not overly constrained by its modest debt levels, and its recent EPS growth is nothing short of stand-out. So on this analysis a high P/E ratio seems reasonable.
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 find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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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.