Is Toromont Industries Ltd.'s (TSE:TIH) High P/E Ratio A Problem For Investors?

The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Toromont Industries Ltd.'s (TSE:TIH), to help you decide if the stock is worth further research. Toromont Industries has a P/E ratio of 18.72, based on the last twelve months. That is equivalent to an earnings yield of about 5.3%.

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How Do You Calculate A P/E Ratio?

The formula for P/E is:

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

Or for Toromont Industries:

P/E of 18.72 = CA$59.97 ÷ CA$3.2 (Based on the trailing twelve months to March 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. 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

P/E ratios primarily reflect market expectations around earnings growth rates. When earnings grow, the 'E' increases, over time. That means unless the share price increases, the P/E will reduce in a few years. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

It's nice to see that Toromont Industries grew EPS by a stonking 42% in the last year. And it has bolstered its earnings per share by 15% per year over the last five years. So we'd generally expect it to have a relatively high P/E ratio.

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

The P/E ratio essentially measures market expectations of a company. As you can see below, Toromont Industries has a higher P/E than the average company (10.4) in the trade distributors industry.

Toromont Industries's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Shareholders are clearly optimistic, but the future is always uncertain. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

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. 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).

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 Toromont Industries's P/E?

Toromont Industries's net debt is 10.0% of its market cap. The market might award it a higher P/E ratio if it had net cash, but its unlikely this low level of net borrowing is having a big impact on the P/E multiple.

The Bottom Line On Toromont Industries's P/E Ratio

Toromont Industries trades on a P/E ratio of 18.7, which is above the CA market average of 14.6. While the company does use modest debt, its recent earnings growth is superb. So on this analysis a high P/E ratio seems reasonable.

When the market is wrong about a stock, it gives savvy investors an opportunity. 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.' 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.