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 Collection House Limited’s (ASX:CLH) P/E ratio could help you assess the value on offer.
Collection House has a price to earnings ratio of 6.97, based on the last twelve months.
In other words, at today’s prices, investors are paying A$6.97 for every A$1 in prior year profit.
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How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Collection House:
P/E of 6.97 = A$1.34 ÷ A$0.19
(Based on the trailing twelve months to June 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each A$1 of company earnings.
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
Companies that shrink earnings per share quickly will rapidly decrease the ‘E’ in the equation.
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.
It’s nice to see that Collection House grew EPS by a stonking 50% in the last year.
How Does Collection House’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 Collection House has a lower P/E than the average (9) P/E for companies in the consumer finance industry.
Its relatively low P/E ratio indicates that Collection House shareholders think it will struggle to do as well as other companies in its industry classification.
While current expectations are low, the stock could be undervalued if the situation is better than the market assumes.
You 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.
That means it doesn’t take debt or cash into account.
In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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.
Is Debt Impacting Collection House’s P/E?
Collection House’s net debt is 43% of its market cap.
This is enough debt that you’d have to make some adjustments before using the P/E ratio to compare it to a company with net cash.
The Bottom Line On Collection House’s P/E Ratio
Collection House’s P/E is 7 which is below average (14.7) in the AU market.
The company hasn’t stretched its balance sheet, and earnings growth was good last year.
The low P/E ratio suggests current market expectations are muted, implying these levels of growth will not continue.
Investors have an opportunity when market expectations about a stock are wrong.
As value investor Benjamin Graham famously said, ‘In the short run, the market is a voting machine but in the long run, it is a weighing machine.’
So this free visual report on analyst forecasts could hold they key to an excellent investment decision.
But note: Collection House may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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.