UK Markets closed

Why McCarthy & Stone plc’s (LON:MCS) High P/E Ratio Isn’t Necessarily A Bad Thing

Simply Wall St

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We’ll show how you can use McCarthy & Stone plc’s (LON:MCS) P/E ratio to inform your assessment of the investment opportunity. McCarthy & Stone has a P/E ratio of 14.6, based on the last twelve months. That is equivalent to an earnings yield of about 6.9%.

View our latest analysis for McCarthy & Stone

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 McCarthy & Stone:

P/E of 14.6 = £1.26 ÷ £0.086 (Based on the year to August 2018.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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

If earnings fall then in the future the ‘E’ will be lower. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.

McCarthy & Stone shrunk earnings per share by 38% over the last year. And over the longer term (5 years) earnings per share have decreased 1.2% annually. This could justify a pessimistic P/E.

How Does McCarthy & Stone’s P/E Ratio Compare To Its Peers?

The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that McCarthy & Stone has a higher P/E than the average (10) P/E for companies in the consumer durables industry.

LSE:MCS Price Estimation Relative to Market, March 11th 2019

McCarthy & Stone’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.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

Don’t forget that the P/E ratio considers market capitalization. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

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).

How Does McCarthy & Stone’s Debt Impact Its P/E Ratio?

McCarthy & Stone has net cash of UK£5.6m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.

The Verdict On McCarthy & Stone’s P/E Ratio

McCarthy & Stone has a P/E of 14.6. That’s below the average in the GB market, which is 15.9. The recent drop in earnings per share would almost certainly temper expectations, the healthy balance sheet means the company retains potential for future growth. If that occurs, the current low P/E could prove to be temporary.

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.

Of course you might be able to find a better stock than McCarthy & Stone. 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 editorial-team@simplywallst.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.