This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll look at Southern Cross Electrical Engineering Limited's (ASX:SXE) P/E ratio and reflect on what it tells us about the company's share price. What is Southern Cross Electrical Engineering's P/E ratio? Well, based on the last twelve months it is 12.18. In other words, at today's prices, investors are paying A$12.18 for every A$1 in prior year profit.
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 Southern Cross Electrical Engineering:
P/E of 12.18 = A$0.54 ÷ A$0.044 (Based on the year to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each A$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
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. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Southern Cross Electrical Engineering increased earnings per share by a whopping 45% last year. In contrast, EPS has decreased by 18%, annually, over 5 years.
How Does Southern Cross Electrical Engineering's P/E Ratio Compare To Its Peers?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. The image below shows that Southern Cross Electrical Engineering has a lower P/E than the average (18.5) P/E for companies in the construction industry.
Its relatively low P/E ratio indicates that Southern Cross Electrical Engineering shareholders think it will struggle to do as well as other companies in its industry classification. Many investors like to buy stocks when the market is pessimistic about their prospects. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The 'Price' in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
Is Debt Impacting Southern Cross Electrical Engineering's P/E?
With net cash of AU$45m, Southern Cross Electrical Engineering has a very strong balance sheet, which may be important for its business. Having said that, at 35% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On Southern Cross Electrical Engineering's P/E Ratio
Southern Cross Electrical Engineering's P/E is 12.2 which is below average (16.1) in the AU market. Not only should the net cash position reduce risk, but the recent growth has been impressive. The below average P/E ratio suggests that market participants don't believe the strong growth will continue. Since analysts are predicting growth will continue, one might expect to see a higher P/E so it may be worth looking closer.
Investors have an opportunity when market expectations about a stock are wrong. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
But note: Southern Cross Electrical Engineering 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).
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If you spot an error that warrants correction, please contact the editor at email@example.com. 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.