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 Whitehaven Coal Limited's (ASX:WHC), to help you decide if the stock is worth further research. Based on the last twelve months, Whitehaven Coal's P/E ratio is 4.53. That means that at current prices, buyers pay A$4.53 for every A$1 in trailing yearly profits.

See our latest analysis for Whitehaven Coal

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for Whitehaven Coal:

P/E of 4.53 = AUD2.42 ÷ AUD0.53 (Based on the trailing twelve months to June 2019.)

Is A High Price-to-Earnings Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing 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.

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

The P/E ratio essentially measures market expectations of a company. If you look at the image below, you can see Whitehaven Coal has a lower P/E than the average (10.7) in the oil and gas industry classification.

This suggests that market participants think Whitehaven Coal will underperform other companies in its industry. 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.

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. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

Whitehaven Coal maintained roughly steady earnings over the last twelve months. But over the longer term (3 years), earnings per share have increased by 196%.

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

The 'Price' in P/E reflects the market capitalization of the company. That means it doesn't take debt or cash into account. 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 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.

Is Debt Impacting Whitehaven Coal's P/E?

Net debt totals just 2.3% of Whitehaven Coal's market cap. It would probably trade on a higher P/E ratio if it had a lot of cash, but I doubt it is having a big impact.

The Verdict On Whitehaven Coal's P/E Ratio

Whitehaven Coal has a P/E of 4.5. That's below the average in the AU market, which is 18.8. The company hasn't stretched its balance sheet, and earnings are improving. The P/E ratio implies the market is cautious about longer term prospects.

Investors should be looking to buy stocks that the market is wrong about. 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 be able to find a better stock than Whitehaven Coal. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.

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. Thank you for reading.