In This Article:
Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use McPherson's Limited's (ASX:MCP) P/E ratio to inform your assessment of the investment opportunity. McPherson's has a P/E ratio of 17.81, based on the last twelve months. That is equivalent to an earnings yield of about 5.6%.
View our latest analysis for McPherson's
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 McPherson's:
P/E of 17.81 = A$2.32 ÷ A$0.13 (Based on the trailing twelve months to June 2019.)
Is A High Price-to-Earnings Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
Does McPherson's 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 McPherson's has a higher P/E than the average (16.1) P/E for companies in the consumer durables industry.
That means that the market expects McPherson's will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
It's great to see that McPherson's grew EPS by 20% in the last year. And it has improved its earnings per share by 5.4% per year over the last three years. This could arguably justify a relatively high P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
Don't forget that the P/E ratio considers market capitalization. That means it doesn't take debt or cash into account. 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).