This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Aritzia Inc.'s (TSE:ATZ), to help you decide if the stock is worth further research. Aritzia has a price to earnings ratio of 25.18, based on the last twelve months. That is equivalent to an earnings yield of about 4.0%.
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 Aritzia:
P/E of 25.18 = CA$19.41 ÷ CA$0.77 (Based on the year to September 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each CA$1 of company earnings. That isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
Does Aritzia Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. As you can see below, Aritzia has a higher P/E than the average company (18.3) in the luxury industry.
Aritzia's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Shareholders are clearly optimistic, but the future is always uncertain. 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. When earnings grow, the 'E' increases, over time. 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.
It's great to see that Aritzia grew EPS by 20% in the last year. And it has bolstered its earnings per share by 52% per year over the last five years. With that performance, you might expect an above average P/E ratio.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. 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.
Is Debt Impacting Aritzia's P/E?
Net debt totals just 3.1% of Aritzia's market cap. The market might award it a higher P/E ratio if it had net cash, but its unlikely this low level of net borrowing is having a big impact on the P/E multiple.
The Verdict On Aritzia's P/E Ratio
Aritzia trades on a P/E ratio of 25.2, which is above its market average of 14.6. Its debt levels do not imperil its balance sheet and it is growing EPS strongly. So on this analysis it seems reasonable that its P/E ratio is above average.
Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. 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.
Of course you might be able to find a better stock than Aritzia. So you may wish to see this free collection of other companies that have grown earnings strongly.
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 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. Thank you for reading.