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This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll look at Gooch & Housego PLC’s (LON:GHH) P/E ratio and reflect on what it tells us about the company’s share price. Based on the last twelve months, Gooch & Housego’s P/E ratio is 51.6. In other words, at today’s prices, investors are paying £51.6 for every £1 in prior year profit.

See our latest analysis for Gooch & Housego

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 Gooch & Housego:

P/E of 51.6 = £15.13 ÷ £0.29 (Based on the trailing twelve months to September 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. All else being equal, it’s better to pay a low price — but as Warren Buffett said, ‘It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.’

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. Earnings growth means that in the future the ‘E’ will be higher. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.

Gooch & Housego shrunk earnings per share by 19% over the last year. But it has grown its earnings per share by 7.6% per year over the last five years.

How Does Gooch & Housego’s P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. The image below shows that Gooch & Housego has a significantly higher P/E than the average (16.6) P/E for companies in the electronic industry.

Gooch & Housego’s P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn’t guaranteed. So investors 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

It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. Thus, the metric does not reflect cash or debt held by the company. 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.

Gooch & Housego’s Balance Sheet

Net debt totals just 2.8% of Gooch & Housego’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 Bottom Line On Gooch & Housego’s P/E Ratio

Gooch & Housego trades on a P/E ratio of 51.6, which is multiples above the GB market average of 15.9. 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.

Investors have an opportunity when market expectations about a stock are wrong. 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. On rare occasion, data errors may occur. Thank you for reading.