Why Franchise Brands plc's (LON:FRAN) High P/E Ratio Isn't Necessarily A Bad Thing

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at Franchise Brands plc's (LON:FRAN) P/E ratio and reflect on what it tells us about the company's share price. Based on the last twelve months, Franchise Brands's P/E ratio is 25.72. That corresponds to an earnings yield of approximately 3.9%.

View our latest analysis for Franchise Brands

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 Franchise Brands:

P/E of 25.72 = £0.86 ÷ £0.034 (Based on the year 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 £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.'

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

The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Franchise Brands has a higher P/E than the average (19.5) P/E for companies in the consumer services industry.

Franchise Brands's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Shareholders are clearly optimistic, but the future is always uncertain. So further research is always essential. I often monitor director buying and selling.

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. Earnings growth means that in the future the 'E' will be higher. And in that case, the P/E ratio itself will drop rather quickly. Then, a lower P/E should attract more buyers, pushing the share price up.

Franchise Brands's earnings made like a rocket, taking off 105% last year. Even better, EPS is up 18% per year over three years. So we'd absolutely expect it to have a relatively high P/E ratio. Regrettably, the longer term performance is poor, with EPS down 5.8% per year over 5 years.

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

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. So it won't reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

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.

Franchise Brands's Balance Sheet

Franchise Brands's net debt is 6.9% of its market cap. It would probably trade on a higher P/E ratio if it had a lot of cash, but I doubt it is having a big impact.

The Verdict On Franchise Brands's P/E Ratio

Franchise Brands's P/E is 25.7 which is above average (15.8) in its market. While the company does use modest debt, its recent earnings growth is superb. So on this analysis a high P/E ratio seems reasonable.

Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free report on the analyst consensus forecasts could help you make a master move on this stock.

But note: Franchise Brands 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).

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.