Why AWF Madison Group Limited's (NZSE:AWF) High P/E Ratio Isn't Necessarily A Bad Thing

Simply Wall St

Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use AWF Madison Group Limited's (NZSE:AWF) P/E ratio to inform your assessment of the investment opportunity. AWF Madison Group has a price to earnings ratio of 50.01, based on the last twelve months. In other words, at today's prices, investors are paying NZ$50.01 for every NZ$1 in prior year profit.

Check out our latest analysis for AWF Madison Group

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for AWF Madison Group:

P/E of 50.01 = NZD1.93 ÷ NZD0.04 (Based on the trailing twelve months to September 2019.)

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 is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.

How Does AWF Madison Group's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. You can see in the image below that the average P/E (25.5) for companies in the professional services industry is lower than AWF Madison Group's P/E.

NZSE:AWF Price Estimation Relative to Market, February 17th 2020

That means that the market expects AWF Madison Group will outperform other companies in its industry. Shareholders are clearly optimistic, but the future is always uncertain. So further research is always essential. I often monitor director buying and selling.

How Growth Rates Impact P/E Ratios

Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means unless the share price falls, the P/E will increase in a few years. Then, a higher P/E might scare off shareholders, pushing the share price down.

AWF Madison Group saw earnings per share decrease by 66% last year. And over the longer term (5 years) earnings per share have decreased 28% annually. This could justify a pessimistic P/E.

Don't Forget: The P/E Does Not Account For Debt or Bank Deposits

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. 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 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 AWF Madison Group's P/E?

AWF Madison Group has net debt equal to 44% of its market cap. While that's enough to warrant consideration, it doesn't really concern us.

The Verdict On AWF Madison Group's P/E Ratio

AWF Madison Group trades on a P/E ratio of 50.0, which is above its market average of 19.9. With modest debt but no EPS growth in the last year, it's fair to say the P/E implies some optimism about future earnings, from the market.

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. We don't have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.

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.

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.