Is Tamawood Limited's (ASX:TWD) High P/E Ratio A Problem For Investors?

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll show how you can use Tamawood Limited's (ASX:TWD) P/E ratio to inform your assessment of the investment opportunity. What is Tamawood's P/E ratio? Well, based on the last twelve months it is 22.22. In other words, at today's prices, investors are paying A$22.22 for every A$1 in prior year profit.

See our latest analysis for Tamawood

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 Tamawood:

P/E of 22.22 = AUD3.39 ÷ AUD0.15 (Based on the trailing twelve months to June 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each AUD1 the company has earned over the last year. 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'.

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

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 (13.7) for companies in the consumer durables industry is lower than Tamawood's P/E.

That means that the market expects Tamawood will outperform other companies in its industry. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

How Growth Rates Impact P/E Ratios

When earnings fall, the 'E' decreases, over time. 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.

Tamawood shrunk earnings per share by 55% over the last year. And EPS is down 5.0% a year, over the last 5 years. This could justify a pessimistic P/E.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

Don't forget that the P/E ratio considers market capitalization. So it won't reflect the advantage of cash, or disadvantage of debt. 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 expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

Is Debt Impacting Tamawood's P/E?

Tamawood has net cash of AU$4.3m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.

The Bottom Line On Tamawood's P/E Ratio

Tamawood trades on a P/E ratio of 22.2, which is above its market average of 18.8. The recent drop in earnings per share might keep value investors away, but the healthy balance sheet means the company retains potential for future growth. If fails to eventuate, the current high P/E could prove to be temporary, as the share price falls.

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

You might be able to find a better buy than Tamawood. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

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.