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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how XP Power Limited's (LON:XPP) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, XP Power has a P/E ratio of 14.83. That means that at current prices, buyers pay £14.83 for every £1 in trailing yearly profits.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for XP Power:
P/E of 14.83 = £23.4 ÷ £1.58 (Based on the year to December 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each £1 of company earnings. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.
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. Earnings growth means that in the future the 'E' will be higher. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.
XP Power increased earnings per share by 6.4% last year. And earnings per share have improved by 10% annually, over the last five years.
Does XP Power 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 (26.1) for companies in the electrical industry is higher than XP Power's P/E.
XP Power's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Many investors like to buy stocks when the market is pessimistic about their prospects. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
Remember: P/E Ratios Don't Consider The Balance Sheet
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn't take debt or cash into account. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
So What Does XP Power's Balance Sheet Tell Us?
Net debt totals 12% of XP Power's market cap. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.
The Bottom Line On XP Power's P/E Ratio
XP Power trades on a P/E ratio of 14.8, which is below the GB market average of 16.3. The company does have a little debt, and EPS is moving in the right direction. If you believe growth will continue - or even increase - then the low P/E may signify opportunity.
Investors should be looking to buy stocks that the market is wrong about. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. 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 XP Power. 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.