This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we’ll show how J. Smart & Co. (Contractors) PLC’s (LON:SMJ) P/E ratio could help you assess the value on offer. Based on the last twelve months, J. Smart (Contractors)’s P/E ratio is 7.11. In other words, at today’s prices, investors are paying £7.11 for every £1 in prior year profit.
See our latest analysis for J. Smart (Contractors)
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 J. Smart (Contractors):
P/E of 7.11 = £1.100 ÷ £0.155 (Based on the trailing twelve months to July 2019.)
(Note: the above calculation results may not be precise due to rounding.)
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.
Does J. Smart (Contractors) Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. We can see in the image below that the average P/E (7.9) for companies in the construction industry is higher than J. Smart (Contractors)’s P/E.
LSE:SMJ Price Estimation Relative to Market April 21st 2020
This suggests that market participants think J. Smart (Contractors) will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. If earnings are growing quickly, then the ‘E’ in the equation will increase faster than it would otherwise. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Notably, J. Smart (Contractors) grew EPS by a whopping 29% in the last year. And its annual EPS growth rate over 5 years is 48%. I’d therefore be a little surprised if its P/E ratio was not relatively high.
Remember: P/E Ratios Don’t Consider The Balance Sheet
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. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on 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.
How Does J. Smart (Contractors)’s Debt Impact Its P/E Ratio?
With net cash of UK£13m, J. Smart (Contractors) has a very strong balance sheet, which may be important for its business. Having said that, at 27% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On J. Smart (Contractors)’s P/E Ratio
J. Smart (Contractors) trades on a P/E ratio of 7.1, which is below the GB market average of 13.5. Not only should the net cash position reduce risk, but the recent growth has been impressive. One might conclude that the market is a bit pessimistic, given the low P/E ratio.
Investors should be looking to buy stocks that the market is wrong about. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. Although we don’t have analyst forecasts shareholders might want to examine this detailed historical graph 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.