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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 show how you can use NZME Limited's (NZSE:NZM) P/E ratio to inform your assessment of the investment opportunity. Looking at earnings over the last twelve months, NZME has a P/E ratio of 8.85. That corresponds to an earnings yield of approximately 11%.
Check out our latest analysis for NZME
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 NZME:
P/E of 8.85 = NZ$0.53 ÷ NZ$0.060 (Based on the trailing twelve months to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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
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 unless the share price increases, the P/E will reduce in a few years. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
NZME saw earnings per share decrease by 44% last year. And it has shrunk its earnings per share by 13% per year over the last five years. This could justify a pessimistic P/E.
Does NZME 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 NZME has a lower P/E than the average (13.1) P/E for companies in the media industry.
Its relatively low P/E ratio indicates that NZME shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with NZME, 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.
Remember: P/E Ratios Don't Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won't reflect the advantage of cash, or disadvantage of debt. 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).