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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll show how you can use Arcontech Group plc's (LON:ARC) P/E ratio to inform your assessment of the investment opportunity. Looking at earnings over the last twelve months, Arcontech Group has a P/E ratio of 15.38. That means that at current prices, buyers pay £15.38 for every £1 in trailing yearly profits.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Arcontech Group:
P/E of 15.38 = £1.3 ÷ £0.085 (Based on the trailing twelve months to December 2018.)
Is A High Price-to-Earnings 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. 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 Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. 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.
Arcontech Group's earnings made like a rocket, taking off 129% last year. And earnings per share have improved by 33% annually, over the last three years. So we'd absolutely expect it to have a relatively high P/E ratio.
Does Arcontech Group Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. We can see in the image below that the average P/E (26.6) for companies in the software industry is higher than Arcontech Group's P/E.
Its relatively low P/E ratio indicates that Arcontech Group shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Arcontech Group, it's quite possible it could surprise on the upside. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
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. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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 spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
Arcontech Group's Balance Sheet
With net cash of UK£3.2m, Arcontech Group has a very strong balance sheet, which may be important for its business. Having said that, at 19% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On Arcontech Group's P/E Ratio
Arcontech Group has a P/E of 15.4. That's around the same as the average in the GB market, which is 16.4. The excess cash it carries is the gravy on top its fast EPS growth. So at a glance we're a bit surprised that Arcontech Group does not have a higher P/E ratio.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. 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.
You might be able to find a better buy than Arcontech Group. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
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.