This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Over the Wire Holdings Limited’s (ASX:OTW) P/E ratio could help you assess the value on offer. Over the Wire Holdings has a P/E ratio of 38.81, based on the last twelve months. That corresponds to an earnings yield of approximately 2.6%.
See our latest analysis for Over the Wire Holdings
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 Over the Wire Holdings:
P/E of 38.81 = A$4.9 ÷ A$0.13 (Based on the trailing twelve months to June 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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
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 unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.
Notably, Over the Wire Holdings grew EPS by a whopping 53% in the last year. And earnings per share have improved by 18% annually, over the last three years. With that performance, I would expect it to have an above average P/E ratio.
How Does Over the Wire Holdings’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Over the Wire Holdings has a higher P/E than the average (25.9) P/E for companies in the it industry.
Its relatively high P/E ratio indicates that Over the Wire Holdings shareholders think it will perform better than other companies in its industry classification. Clearly the market expects growth, but it isn’t guaranteed. So investors 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. That means it doesn’t take debt or cash into account. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.