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 Smart Metering Systems plc’s (LON:SMS) P/E ratio to inform your assessment of the investment opportunity. Smart Metering Systems has a P/E ratio of 36.67, based on the last twelve months. That means that at current prices, buyers pay £36.67 for every £1 in trailing yearly profits.
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How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Smart Metering Systems:
P/E of 36.67 = £5.51 ÷ £0.15 (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 isn’t necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Growth Rates Impact P/E Ratios
If earnings fall then in the future the ‘E’ will be lower. That means unless the share price falls, the P/E will increase in a few years. A higher P/E should indicate the stock is expensive relative to others — and that may encourage shareholders to sell.
Smart Metering Systems saw earnings per share decrease by 14% last year. But over the longer term (5 years) earnings per share have increased by 17%.
How Does Smart Metering Systems’s P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. You can see in the image below that the average P/E (16.5) for companies in the electronic industry is lower than Smart Metering Systems’s P/E.
That means that the market expects Smart Metering Systems will outperform other companies in its industry. 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
The ‘Price’ in P/E reflects the market capitalization of the company. 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 expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
How Does Smart Metering Systems’s Debt Impact Its P/E Ratio?
Smart Metering Systems’s net debt is 18% of its market cap. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.
The Bottom Line On Smart Metering Systems’s P/E Ratio
Smart Metering Systems trades on a P/E ratio of 36.7, which is above the GB market average of 15.6. With some debt but no EPS growth last year, the market has high expectations of future profits.
Investors have an opportunity when market expectations about a stock are wrong. 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 visual report on analyst forecasts could hold they key to an excellent investment decision.
You might be able to find a better buy than Smart Metering Systems. 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).
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 firstname.lastname@example.org.