This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Millennium & Copthorne Hotels New Zealand Limited's (NZSE:MCK), to help you decide if the stock is worth further research. Based on the last twelve months, Millennium & Copthorne Hotels New Zealand's P/E ratio is 9.19. In other words, at today's prices, investors are paying NZ$9.19 for every NZ$1 in prior year profit.

View our latest analysis for Millennium & Copthorne Hotels New Zealand

How Do You Calculate A P/E Ratio?

The formula for P/E is:

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

Or for Millennium & Copthorne Hotels New Zealand:

P/E of 9.19 = NZ$2.50 ÷ NZ$0.27 (Based on the year to June 2019.)

Is A High Price-to-Earnings 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 is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.

Does Millennium & Copthorne Hotels New Zealand Have A Relatively High Or Low P/E For Its Industry?

We can get an indication of market expectations by looking at the P/E ratio. We can see in the image below that the average P/E (16.8) for companies in the hospitality industry is higher than Millennium & Copthorne Hotels New Zealand's P/E.

Its relatively low P/E ratio indicates that Millennium & Copthorne Hotels New Zealand shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Millennium & Copthorne Hotels New Zealand, it's quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.

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. That means even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Millennium & Copthorne Hotels New Zealand saw earnings per share decrease by 12% last year. But it has grown its earnings per share by 35% per year over the last five years.

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

The 'Price' in P/E reflects the market capitalization of the company. So it won't reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

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.

Is Debt Impacting Millennium & Copthorne Hotels New Zealand's P/E?

With net cash of NZ$66m, Millennium & Copthorne Hotels New Zealand has a very strong balance sheet, which may be important for its business. Having said that, at 15% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Verdict On Millennium & Copthorne Hotels New Zealand's P/E Ratio

Millennium & Copthorne Hotels New Zealand has a P/E of 9.2. That's below the average in the NZ market, which is 20.3. Falling earnings per share are likely to be keeping potential buyers away, the relatively strong balance sheet will allow the company time to invest in growth. If it achieves that, then there's real potential that the low P/E could eventually indicate undervaluation.

Investors have an opportunity when market expectations about a stock are wrong. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. We don't have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.