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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 Auto Trader Group plc's (LON:AUTO) P/E ratio could help you assess the value on offer. What is Auto Trader Group's P/E ratio? Well, based on the last twelve months it is 28.08. In other words, at today's prices, investors are paying £28.08 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 Auto Trader Group:
P/E of 28.08 = £5.29 ÷ £0.19 (Based on the year to September 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each £1 the company has earned over the last year. 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
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. When earnings grow, the 'E' increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.
Auto Trader Group increased earnings per share by an impressive 13% over the last twelve months. And earnings per share have improved by 47% annually, over the last three years. So one might expect an above average P/E ratio.
Does Auto Trader Group Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. You can see in the image below that the average P/E (22.2) for companies in the interactive media and services industry is lower than Auto Trader Group's P/E.
Its relatively high P/E ratio indicates that Auto Trader Group shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn't guarantee future growth. So further research is always essential. I often monitor director buying and selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The 'Price' in P/E reflects the market capitalization of the company. So it won't reflect the advantage of cash, or disadvantage of debt. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
Is Debt Impacting Auto Trader Group's P/E?
Auto Trader Group has net debt worth just 6.8% of its market capitalization. So it doesn't have as many options as it would with net cash, but its debt would not have much of an impact on its P/E ratio.
The Verdict On Auto Trader Group's P/E Ratio
Auto Trader Group trades on a P/E ratio of 28.1, which is above the GB market average of 16. Its debt levels do not imperil its balance sheet and it is growing EPS strongly. Therefore, it's not particularly surprising that it has a above average P/E ratio.
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 Auto Trader Group. 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 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.