This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll look at G8 Education Limited’s (ASX:GEM) P/E ratio and reflect on what it tells us about the company’s share price. G8 Education has a P/E ratio of 17.05, based on the last twelve months. That corresponds to an earnings yield of approximately 5.9%.

View our latest analysis for G8 Education

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 G8 Education:

P/E of 17.05 = A$2.8 ÷ A$0.16 (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. 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.’

How Growth Rates Impact P/E Ratios

If earnings fall then in the future the ‘E’ will be lower. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.

G8 Education saw earnings per share decrease by 25% last year. But EPS is up 12% over the last 5 years. And it has shrunk its earnings per share by 6.8% per year over the last three years. This growth rate might warrant a low P/E ratio. This growth rate might warrant a low P/E ratio.

How Does G8 Education’s P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. As you can see below G8 Education has a P/E ratio that is fairly close for the average for the consumer services industry, which is 16.8.

That indicates that the market expects G8 Education will perform roughly in line with other companies in its industry. So if G8 Education actually outperforms its peers going forward, that should be a positive for the share price. Checking factors such as the tenure of the board and management could help you form your own view on if that will happen.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

Don’t forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining cash).

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 G8 Education’s Debt Impact Its P/E Ratio?

G8 Education has net debt worth 25% of its market capitalization. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.

The Verdict On G8 Education’s P/E Ratio

G8 Education’s P/E is 17 which is above average (15.2) in the AU market. With modest debt but no EPS growth in the last year, it’s fair to say the P/E implies some optimism about future earnings, from the market.

Investors should be looking to buy stocks that the market is wrong about. 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 report on the analyst consensus forecasts could help you make a master move on this stock.

You might be able to find a better buy than G8 Education. 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 editorial-team@simplywallst.com.