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Should You Be Tempted To Sell Petrofac Limited (LON:PFC) Because Of Its P/E Ratio?

The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how Petrofac Limited's (LON:PFC) P/E ratio could help you assess the value on offer. Petrofac has a P/E ratio of 11.29, based on the last twelve months. In other words, at today's prices, investors are paying £11.29 for every £1 in prior year profit.

See our latest analysis for Petrofac

How Do You Calculate A P/E Ratio?

The formula for P/E is:

Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)

Or for Petrofac:

P/E of 11.29 = $2.454 ÷ $0.217 (Based on the trailing twelve months to December 2019.)

(Note: the above calculation uses the share price in the reporting currency, namely USD and the calculation results may not be precise due to rounding.)

Is A High P/E Ratio Good?

A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. 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 Does Petrofac'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, Petrofac has a higher P/E than the average company (8.8) in the energy services industry.

LSE:PFC Price Estimation Relative to Market March 30th 2020
LSE:PFC Price Estimation Relative to Market March 30th 2020

That means that the market expects Petrofac will outperform other companies in its industry. Shareholders are clearly optimistic, but the future is always uncertain. 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

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. 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.

It's great to see that Petrofac grew EPS by 15% in the last year. And its annual EPS growth rate over 3 years is 320%. So one might expect an above average P/E ratio. But earnings per share are down 9.2% per year over the last five years.

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

Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. 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.

How Does Petrofac's Debt Impact Its P/E Ratio?

Petrofac has net cash of US$13m. 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 Petrofac's P/E Ratio

Petrofac has a P/E of 11.3. That's below the average in the GB market, which is 12.5. Not only should the net cash position reduce risk, but the recent growth has been impressive. The relatively low P/E ratio implies the market is pessimistic.

When the market is wrong about a stock, it gives savvy investors an opportunity. 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 be able to find a better stock than Petrofac. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.