This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll look at Persimmon Plc's (LON:PSN) P/E ratio and reflect on what it tells us about the company's share price. Persimmon has a price to earnings ratio of 7.84, based on the last twelve months. That means that at current prices, buyers pay £7.84 for every £1 in trailing yearly profits.
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 Persimmon:
P/E of 7.84 = £21.75 ÷ £2.78 (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 £1 the company has earned over the last year. That isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Does Persimmon's P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Persimmon has a lower P/E than the average (10.1) P/E for companies in the consumer durables industry.
This suggests that market participants think Persimmon will underperform other companies in its industry. Since the market seems unimpressed with Persimmon, 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. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means even if the current P/E is high, it will reduce over time if the share price stays flat. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Persimmon increased earnings per share by 2.7% last year. And it has bolstered its earnings per share by 21% per year over the last five years.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. That means it doesn't take debt or cash into account. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
So What Does Persimmon's Balance Sheet Tell Us?
With net cash of UK£833m, Persimmon has a very strong balance sheet, which may be important for its business. Having said that, at 12% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Verdict On Persimmon's P/E Ratio
Persimmon has a P/E of 7.8. That's below the average in the GB market, which is 16.0. Earnings improved over the last year. And the net cash position gives the company many options. So it's strange that the low P/E indicates low expectations.
When the market is wrong about a stock, it gives savvy investors an opportunity. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course you might be able to find a better stock than Persimmon. So you may wish to see this free collection of other companies that have grown earnings strongly.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Thank you for reading.