Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!
Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use ABIOMED, Inc.'s (NASDAQ:ABMD) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, ABIOMED's P/E ratio is 44.89. In other words, at today's prices, investors are paying $44.89 for every $1 in prior year profit.
How Do You Calculate ABIOMED's P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for ABIOMED:
P/E of 44.89 = $258.92 ÷ $5.77 (Based on the year to March 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. 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 Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. 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.
In the last year, ABIOMED grew EPS like Taylor Swift grew her fan base back in 2010; the 127% gain was both fast and well deserved. The cherry on top is that the five year growth rate was an impressive 99% per year. So I'd be surprised if the P/E ratio was not above average.
Does ABIOMED 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. You can see in the image below that the average P/E (40) for companies in the medical equipment industry is lower than ABIOMED's P/E.
That means that the market expects ABIOMED will outperform other companies in its industry. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should delve deeper. I like to check if company insiders have been buying or selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won't reflect the advantage of cash, or disadvantage of debt. 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 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 ABIOMED's P/E?
Since ABIOMED holds net cash of US$492m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On ABIOMED's P/E Ratio
ABIOMED has a P/E of 44.9. That's higher than the average in the US market, which is 18. Its net cash position is the cherry on top of its superb EPS growth. So based on this analysis we'd expect ABIOMED to have a high P/E ratio.
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.' 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 find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E 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 email@example.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.