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 Dewhurst PLC's (LON:DWHT) P/E ratio could help you assess the value on offer. Dewhurst has a price to earnings ratio of 18.63, based on the last twelve months. In other words, at today's prices, investors are paying £18.63 for every £1 in prior year profit.
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 Dewhurst:
P/E of 18.63 = £9.25 ÷ £0.50 (Based on the year to March 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 £1 the company has earned over the last year. 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 Does Dewhurst's P/E Ratio Compare To Its Peers?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. As you can see below Dewhurst has a P/E ratio that is fairly close for the average for the electrical industry, which is 19.9.
Dewhurst's P/E tells us that market participants think its prospects are roughly in line with its industry. The company could surprise by performing better than average, in the future. I would further inform my view by checking insider buying and selling., among other things.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. 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.
Dewhurst had pretty flat EPS growth in the last year. But over the longer term (5 years) earnings per share have increased by 24%.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
Don't forget that the P/E ratio considers market capitalization. So it won't reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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.
How Does Dewhurst's Debt Impact Its P/E Ratio?
The extra options and safety that comes with Dewhurst's UK£6.2m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Verdict On Dewhurst's P/E Ratio
Dewhurst's P/E is 18.6 which is above average (16.9) in its market. The recent drop in earnings per share might keep value investors away, but the net cash position means the company has time to improve: and the high P/E suggests the market thinks it will.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
You might be able to find a better buy than Dewhurst. 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).
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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.