This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll look at Washington H. Soul Pattinson and Company Limited’s (ASX:SOL) P/E ratio and reflect on what it tells us about the company’s share price. Washington H. Soul Pattinson has a P/E ratio of 27.42, based on the last twelve months. That means that at current prices, buyers pay A$27.42 for every A$1 in trailing yearly profits.

Check out our latest analysis for Washington H. Soul Pattinson

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for Washington H. Soul Pattinson:

P/E of 27.42 = A$30.56 ÷ A$1.11 (Based on the trailing twelve months to July 2018.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each A$1 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.’

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. When earnings grow, the ‘E’ increases, over time. That means unless the share price increases, the P/E will reduce in a few years. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Washington H. Soul Pattinson’s earnings per share fell by 20% in the last twelve months. But over the longer term (5 years) earnings per share have increased by 27%.

How Does Washington H. Soul Pattinson’s P/E Ratio Compare To Its Peers?

The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Washington H. Soul Pattinson has a higher P/E than the average (11.5) P/E for companies in the oil and gas industry.

Washington H. Soul Pattinson’s P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn’t guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

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. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

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 Washington H. Soul Pattinson’s Debt Impact Its P/E Ratio?

Since Washington H. Soul Pattinson holds net cash of AU$569m, it can spend on growth, justifying a higher P/E ratio than otherwise.

The Verdict On Washington H. Soul Pattinson’s P/E Ratio

Washington H. Soul Pattinson trades on a P/E ratio of 27.4, which is above the AU market average of 16.1. Falling earnings per share is probably keeping traditional 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.

Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth — so investors can make money when fast growth is not fully appreciated. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

You might be able to find a better buy than Washington H. Soul Pattinson. 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).

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.

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. Thank you for reading.