This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Zodiac Energy Limited’s (NSE:ZODIAC) P/E ratio could help you assess the value on offer. Zodiac Energy has a P/E ratio of 8.12, based on the last twelve months. That corresponds to an earnings yield of approximately 12%.
View our latest analysis for Zodiac Energy
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Zodiac Energy:
P/E of 8.12 = ₹23 ÷ ₹2.83 (Based on the year to September 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each ₹1 of company earnings. 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
P/E ratios primarily reflect market expectations around earnings growth rates. 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, Zodiac Energy grew EPS by a whopping 26% in the last year. And it has bolstered its earnings per share by 41% per year over the last five years. I’d therefore be a little surprised if its P/E ratio was not relatively high.
How Does Zodiac Energy’s P/E Ratio Compare To Its Peers?
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 (15.7) for companies in the electrical industry is higher than Zodiac Energy’s P/E.
Its relatively low P/E ratio indicates that Zodiac Energy shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Zodiac Energy, 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.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don’t forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.