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 Renishaw plc’s (LON:RSW) P/E ratio could help you assess the value on offer. Renishaw has a price to earnings ratio of 21.55, based on the last twelve months. That means that at current prices, buyers pay £21.55 for every £1 in trailing yearly profits.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Renishaw:
P/E of 21.55 = £39.18 ÷ £1.82 (Based on the year to June 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. 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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Renishaw increased earnings per share by a whopping 29% last year. And its annual EPS growth rate over 5 years is 10%. So we’d generally expect it to have a relatively high P/E ratio.
How Does Renishaw’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. As you can see below, Renishaw has a higher P/E than the average company (17.2) in the electronic industry.
Its relatively high P/E ratio indicates that Renishaw shareholders think it will perform better than other companies in its industry classification. Shareholders are clearly optimistic, but the future is always uncertain. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. Thus, the metric does not reflect cash or debt held by the company. 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 Renishaw’s Debt Impact Its P/E Ratio?
Since Renishaw holds net cash of UK£104m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Renishaw’s P/E Ratio
Renishaw’s P/E is 21.5 which is above average (15) in the GB market. Its net cash position supports a higher P/E ratio, as does its solid recent earnings growth. So it does not seem strange that the P/E is above average.
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To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.