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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how Itera ASA's (OB:ITE) P/E ratio could help you assess the value on offer. Itera has a P/E ratio of 17.23, based on the last twelve months. In other words, at today's prices, investors are paying NOK17.23 for every NOK1 in prior year profit.
Check out our latest analysis for Itera
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 Itera:
P/E of 17.23 = NOK7.42 ÷ NOK0.43 (Based on the year to March 2019.)
Is A High P/E Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing 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. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Itera increased earnings per share by a whopping 27% last year. And its annual EPS growth rate over 5 years is 17%. I'd therefore be a little surprised if its P/E ratio was not relatively high.
Does Itera Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Itera has a P/E ratio that is roughly in line with the it industry average (17.5).
That indicates that the market expects Itera will perform roughly in line with other companies in its industry. So if Itera 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
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.