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Why Volution Group plc's (LON:FAN) High P/E Ratio Isn't Necessarily A Bad Thing

Simply Wall St

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 Volution Group plc's (LON:FAN) P/E ratio to inform your assessment of the investment opportunity. Volution Group has a price to earnings ratio of 26.23, based on the last twelve months. That means that at current prices, buyers pay £26.23 for every £1 in trailing yearly profits.

View our latest analysis for Volution Group

How Do You Calculate A P/E Ratio?

The formula for P/E is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for Volution Group:

P/E of 26.23 = GBP2.41 ÷ GBP0.09 (Based on the trailing twelve months to July 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each GBP1 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'.

How Does Volution Group's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. You can see in the image below that the average P/E (17.6) for companies in the building industry is lower than Volution Group's P/E.

LSE:FAN Price Estimation Relative to Market, January 27th 2020

That means that the market expects Volution Group will outperform other companies in its industry. Shareholders are clearly optimistic, but the future is always uncertain. So further research is always essential. I often monitor director buying and selling.

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. And in that case, the P/E ratio itself will drop rather quickly. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

Volution Group increased earnings per share by a whopping 37% last year. And its annual EPS growth rate over 3 years is 5.5%. With that performance, I would expect it to have an above average P/E ratio.

Remember: P/E Ratios Don't Consider The Balance Sheet

Don't forget that the P/E ratio considers market capitalization. So it won't reflect the advantage of cash, or disadvantage of debt. 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 Volution Group's Balance Sheet Tell Us?

Volution Group has net debt worth 15% of its market capitalization. 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 Volution Group's P/E Ratio

Volution Group trades on a P/E ratio of 26.2, which is above its market average of 18.3. While the company does use modest debt, its recent earnings growth is superb. So on this analysis a high P/E ratio seems reasonable.

When the market is wrong about a stock, it gives savvy investors an opportunity. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.

But note: Volution Group 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 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.