This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll look at AltaGas Ltd.'s (TSE:ALA) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, AltaGas has a P/E ratio of 17.38. That means that at current prices, buyers pay CA$17.38 for every CA$1 in trailing yearly profits.

Check out our latest analysis for AltaGas

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 AltaGas:

P/E of 17.38 = CA$19.06 ÷ CA$1.1 (Based on the trailing twelve months 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 CA$1 the company has earned over the last year. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.'

Does AltaGas Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio indicates whether the market has higher or lower expectations of a company. As you can see below AltaGas has a P/E ratio that is fairly close for the average for the gas utilities industry, which is 17.4.

That indicates that the market expects AltaGas will perform roughly in line with other companies in its industry. So if AltaGas actually outperforms its peers going forward, that should be a positive for the share price. I would further inform my view by checking insider buying and selling., among other things.

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the 'E' will be higher. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

AltaGas's earnings made like a rocket, taking off 239% last year. Even better, EPS is up 63% per year over three years. So you might say it really deserves to have an above-average P/E ratio. Unfortunately, earnings per share are down 4.2% a year, over 5 years.

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. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.

So What Does AltaGas's Balance Sheet Tell Us?

AltaGas's net debt is considerable, at 153% of its market cap. If you want to compare its P/E ratio to other companies, you must keep in mind that these debt levels would usually warrant a relatively low P/E.

The Verdict On AltaGas's P/E Ratio

AltaGas has a P/E of 17.4. That's higher than the average in its market, which is 14.2. Its meaningful level of debt should warrant a lower P/E ratio, but the fast EPS growth is a positive. So despite the debt it is, perhaps, not unreasonable to see a high P/E ratio.

Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E 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 editorial-team@simplywallst.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.