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This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Gesco AG's (ETR:GSC1), to help you decide if the stock is worth further research. Based on the last twelve months, Gesco's P/E ratio is 9.14. In other words, at today's prices, investors are paying €9.14 for every €1 in prior year profit.
See our latest analysis for Gesco
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 Gesco:
P/E of 9.14 = €20.30 ÷ €2.22 (Based on the year to June 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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.
Does Gesco Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. If you look at the image below, you can see Gesco has a lower P/E than the average (15.1) in the machinery industry classification.
Gesco's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Since the market seems unimpressed with Gesco, it's quite possible it could surprise on the upside. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
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. Earnings growth means that in the future the 'E' will be higher. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
It's nice to see that Gesco grew EPS by a stonking 34% in the last year. And earnings per share have improved by 5.0% annually, over the last five years. I'd therefore be a little surprised if its P/E ratio was not relatively high.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. So it won't reflect the advantage of cash, or disadvantage of debt. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.