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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 CRH Medical Corporation's (TSE:CRH) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, CRH Medical has a P/E ratio of 63.12. In other words, at today's prices, investors are paying CA$63.12 for every CA$1 in prior year profit.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)
Or for CRH Medical:
P/E of 63.12 = $2.79 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $0.044 (Based on the trailing twelve months to March 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 is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
How Growth Rates Impact P/E Ratios
When earnings fall, the 'E' decreases, over time. That means unless the share price falls, the P/E will increase in a few years. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.
CRH Medical saw earnings per share decrease by 73% last year. And it has shrunk its earnings per share by 3.6% per year over the last five years. This could justify a pessimistic P/E.
How Does CRH Medical's P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that CRH Medical has a higher P/E than the average (45.2) P/E for companies in the healthcare industry.
That means that the market expects CRH Medical will outperform other companies in its industry. 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.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
CRH Medical's Balance Sheet
CRH Medical's net debt equates to 30% of its market capitalization. You'd want to be aware of this fact, but it doesn't bother us.
The Bottom Line On CRH Medical's P/E Ratio
CRH Medical's P/E is 63.1 which suggests the market is more focussed on the future opportunity rather than the current level of earnings. 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.
Investors have an opportunity when market expectations about a stock are wrong. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine.' 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.
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.