This article is for investors who would like to improve their understanding of 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 16.07, based on the last twelve months. That corresponds to an earnings yield of approximately 6.2%.

View our latest analysis for London Security

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for London Security:

P/E of 16.07 = £19.5 ÷ £1.21 (Based on the trailing twelve months to June 2018.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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 Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. When earnings grow, the ‘E’ increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.

London Security saw earnings per share improve by -6.2% last year. And it has bolstered its earnings per share by 2.3% per year over the last five years.

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. The image below shows that London Security has a lower P/E than the average (18) P/E for companies in the machinery industry.

Its relatively low P/E ratio indicates that London Security 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. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

Remember: P/E Ratios Don’t Consider The Balance Sheet

Don’t forget that the P/E ratio considers market capitalization. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

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 London Security’s P/E?

The extra options and safety that comes with London Security’s UK£19m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.

The Bottom Line On London Security’s P/E Ratio

London Security’s P/E is 16.1 which is about average (15) in the GB market. Recent earnings growth wasn’t bad. And the healthy balance sheet means the company can sustain growth. But the P/E suggests shareholders have some doubts.

When the market is wrong about a stock, it gives savvy investors an opportunity. People often underestimate remarkable growth — so investors can make money when fast growth is not fully appreciated. Although we don’t have analyst forecasts, shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.

Of course you might be able to find a better stock than London Security. So you may wish to see this free collection of other companies that have grown earnings strongly.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.