The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll show how you can use London Security plc's (LON:LSC) P/E ratio to inform your assessment of the investment opportunity. London Security has a price to earnings ratio of 16.03, based on the last twelve months. That means that at current prices, buyers pay £16.03 for every £1 in trailing yearly profits.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for London Security:
P/E of 16.03 = £21.3 ÷ £1.33 (Based on the year to June 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each £1 of company earnings. 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 London Security's P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. If you look at the image below, you can see London Security has a lower P/E than the average (17.9) in the machinery industry classification.
This suggests that market participants think London Security will underperform other companies in its industry. Many investors like to buy stocks when the market is pessimistic about their prospects. You should delve deeper. I like to check if company insiders have been buying or selling.
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. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. And in that case, the P/E ratio itself will drop rather quickly. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
London Security's earnings per share grew by -9.4% in the last twelve months. And earnings per share have improved by 3.2% annually, over the last five years.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
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 London Security's Balance Sheet Tell Us?
Since London Security holds net cash of UK£20m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On London Security's P/E Ratio
London Security trades on a P/E ratio of 16, which is fairly close to the GB market average of 16. Earnings improved over the last year. Also positive, the relatively strong balance sheet will allow for investment in growth. If this occurs the current P/E might prove to signify undervaluation.
Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine.' Although we don't have analyst forecasts, you might want to assess this data-rich visualization of earnings, revenue and cash flow.
But note: London Security may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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.
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.