Why Lechwerke AG's (FRA:LEC) High P/E Ratio Isn't Necessarily A Bad Thing

Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at Lechwerke AG's (FRA:LEC) P/E ratio and reflect on what it tells us about the company's share price. Lechwerke has a price to earnings ratio of 26.10, based on the last twelve months. That means that at current prices, buyers pay €26.10 for every €1 in trailing yearly profits.

Check out our latest analysis for Lechwerke

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for Lechwerke:

P/E of 26.10 = €103.000 ÷ €3.947 (Based on the trailing twelve months to December 2019.)

(Note: the above calculation results may not be precise due to rounding.)

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 Lechwerke'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. The image below shows that Lechwerke has a higher P/E than the average (10.5) P/E for companies in the electric utilities industry.

Its relatively high P/E ratio indicates that Lechwerke shareholders think it will perform better than other companies in its industry classification. 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

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 even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Lechwerke's earnings made like a rocket, taking off 76% last year. Having said that, the average EPS growth over the last three years wasn't so good, coming in at 14%.

Don't Forget: The P/E Does Not Account For Debt or Bank Deposits

The 'Price' in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).

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.

So What Does Lechwerke's Balance Sheet Tell Us?

Lechwerke has net cash of €486k. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.

The Verdict On Lechwerke's P/E Ratio

Lechwerke's P/E is 26.1 which is above average (17.4) in its market. The excess cash it carries is the gravy on top its fast EPS growth. To us, this is the sort of company that we would expect to carry an above average price tag (relative to earnings).

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. We don't have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.

But note: Lechwerke may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio 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.