This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll look at Virtus Health Limited's (ASX:VRT) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, Virtus Health has a P/E ratio of 10.86. That is equivalent to an earnings yield of about 9.2%.
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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 Virtus Health:
P/E of 10.86 = A$3.89 ÷ A$0.36 (Based on the year to December 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 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
Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. Then, a higher P/E might scare off shareholders, pushing the share price down.
Virtus Health shrunk earnings per share by 3.9% last year. But over the longer term (5 years) earnings per share have increased by 9.1%. And over the longer term (3 years) earnings per share have decreased 2.2% annually. So we might expect a relatively low P/E.
How Does Virtus Health's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Virtus Health has a lower P/E than the average (18.5) P/E for companies in the healthcare industry.
Its relatively low P/E ratio indicates that Virtus Health 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. You should delve deeper. I like to check if company insiders have been buying or selling.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
The 'Price' in P/E reflects the market capitalization of the company. So it won't reflect the advantage of cash, or disadvantage of debt. 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.
Virtus Health's Balance Sheet
Net debt totals 53% of Virtus Health's market cap. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.
The Verdict On Virtus Health's P/E Ratio
Virtus Health trades on a P/E ratio of 10.9, which is below the AU market average of 16. The P/E reflects market pessimism that probably arises from the lack of recent EPS growth, paired with significant leverage.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
You might be able to find a better buy than Virtus Health. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
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.