The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We’ll look at Green Cross Health Limited’s (NZSE:GXH) P/E ratio and reflect on what it tells us about the company’s share price. Green Cross Health has a price to earnings ratio of 10.24, based on the last twelve months. That means that at current prices, buyers pay NZ$10.24 for every NZ$1 in trailing yearly profits.

See our latest analysis for Green Cross Health

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for Green Cross Health:

P/E of 10.24 = NZ$1.16 ÷ NZ$0.11 (Based on the year to September 2018.)

Is A High P/E Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each NZ$1 the company has earned over the last year. That isn’t a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business’s prospects, relative to stocks with a lower P/E.

How Growth Rates Impact P/E Ratios

Companies that shrink earnings per share quickly will rapidly decrease the ‘E’ in the equation. That means even if the current P/E is low, it will increase over time if the share price stays flat. Then, a higher P/E might scare off shareholders, pushing the share price down.

Green Cross Health’s earnings per share fell by 12% in the last twelve months. But EPS is up 2.3% over the last 5 years. And EPS is down 2.4% a year, over the last 3 years. This growth rate might warrant a low P/E ratio.

How Does Green Cross Health’s P/E Ratio Compare To Its Peers?

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 Green Cross Health has a lower P/E than the average (16.1) in the consumer retailing industry classification.

Green Cross Health’s P/E tells us that market participants think it will not fare as well as its peers in the same industry. 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.

Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits

The ‘Price’ in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).

Green Cross Health’s Balance Sheet

Green Cross Health’s net debt is 27% of its market cap. This is a reasonably significant level of debt — all else being equal you’d expect a much lower P/E than if it had net cash.

The Bottom Line On Green Cross Health’s P/E Ratio

Green Cross Health trades on a P/E ratio of 10.2, which is below the NZ market average of 15.9. With only modest debt, it’s likely the lack of EPS growth at least partially explains the pessimism implied by the P/E ratio.

Investors should be looking to buy stocks that the market is wrong about. 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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

But note: Green Cross Health 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 editorial-team@simplywallst.com.