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Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how ASX Limited's (ASX:ASX) P/E ratio could help you assess the value on offer. ASX has a P/E ratio of 33.31, based on the last twelve months. That means that at current prices, buyers pay A$33.31 for every A$1 in trailing yearly profits.
See our latest analysis for ASX
How Do You Calculate ASX's P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for ASX:
P/E of 33.31 = A$79.29 ÷ A$2.38 (Based on the year to December 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each A$1 of company earnings. 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. 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. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
ASX's earnings per share grew by -3.4% in the last twelve months. And its annual EPS growth rate over 5 years is 3.8%.
Does ASX Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. The image below shows that ASX has a higher P/E than the average (17.2) P/E for companies in the capital markets industry.
That means that the market expects ASX 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.
Remember: P/E Ratios Don't Consider The Balance Sheet
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. So it won't reflect the advantage of cash, or disadvantage of debt. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
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.