The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at Western Areas Limited's (ASX:WSA) P/E ratio and reflect on what it tells us about the company's share price. Based on the last twelve months, Western Areas's P/E ratio is 14.24. In other words, at today's prices, investors are paying A$14.24 for every A$1 in prior year profit.
View our latest analysis for Western Areas
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 Western Areas:
P/E of 14.24 = A$2.120 ÷ A$0.149 (Based on the trailing twelve months to December 2019.)
(Note: the above calculation results may not be precise due to rounding.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each A$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.
How Does Western Areas's P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Western Areas has a higher P/E than the average (9.4) P/E for companies in the metals and mining industry.
Its relatively high P/E ratio indicates that Western Areas shareholders think it will perform better than other companies in its industry classification. Shareholders are clearly optimistic, but the future is always uncertain. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
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. When earnings grow, the 'E' increases, over time. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.
In the last year, Western Areas grew EPS like Taylor Swift grew her fan base back in 2010; the 404% gain was both fast and well deserved. Regrettably, the longer term performance is poor, with EPS down 6.6% per year over 5 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. 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.