The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We’ll show how you can use Diversified Royalty Corp.’s (TSE:DIV) P/E ratio to inform your assessment of the investment opportunity. Looking at earnings over the last twelve months, Diversified Royalty has a P/E ratio of 32.71. In other words, at today’s prices, investors are paying CA$32.71 for every CA$1 in prior year profit.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Diversified Royalty:
P/E of 32.71 = CAD3.30 ÷ CAD0.10 (Based on the year to September 2019.)
Is A High P/E Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. That isn’t necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Does Diversified Royalty’s P/E Ratio Compare To Its Peers?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. As you can see below, Diversified Royalty has a higher P/E than the average company (13.5) in the specialty retail industry.
Its relatively high P/E ratio indicates that Diversified Royalty shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn’t guarantee future growth. So investors should delve deeper.
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. When earnings grow, the ‘E’ increases, over time. And in that case, the P/E ratio itself will drop rather quickly. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
Diversified Royalty’s earnings per share fell by 14% in the last twelve months. But over the longer term (3 years), earnings per share have increased by 17%. And over the longer term (5 years) earnings per share have decreased 6.2% 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. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
So What Does Diversified Royalty’s Balance Sheet Tell Us?
Diversified Royalty’s net debt is 23% of its market cap. That’s enough debt to impact the P/E ratio a little; so keep it in mind if you’re comparing it to companies without debt.
The Verdict On Diversified Royalty’s P/E Ratio
Diversified Royalty’s P/E is 32.7 which is above average (16.2) in its market. With some debt but no EPS growth last year, the market has high expectations of future profits.
When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is better than it expects, you can make money by buying and holding for the long term.