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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We’ll show how you can use Neogen Corporation’s (NASDAQ:NEOG) P/E ratio to inform your assessment of the investment opportunity. Neogen has a P/E ratio of 48.16, based on the last twelve months. That corresponds to an earnings yield of approximately 2.1%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Neogen:
P/E of 48.16 = $60.92 ÷ $1.27 (Based on the year to November 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn’t a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business’s prospects, relative to stocks with a lower P/E.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. 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.
Neogen increased earnings per share by an impressive 24% over the last twelve months. And it has bolstered its earnings per share by 17% per year over the last five years. With that performance, you might expect an above average P/E ratio.
How Does Neogen’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (48) for companies in the medical equipment industry is roughly the same as Neogen’s P/E.
Its P/E ratio suggests that Neogen shareholders think that in the future it will perform about the same as other companies in its industry classification. So if Neogen actually outperforms its peers going forward, that should be a positive for the share price. Further research into factors such asmanagement tenure, could help you form your own view on whether that is likely.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
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. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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.
Neogen’s Balance Sheet
The extra options and safety that comes with Neogen’s US$241m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Bottom Line On Neogen’s P/E Ratio
Neogen’s P/E is 48.2 which is above average (16.7) in the US market. Its net cash position supports a higher P/E ratio, as does its solid recent earnings growth. So it is not surprising the market is probably extrapolating recent growth well into the future, reflected in the relatively high P/E ratio.
When the market is wrong about a stock, it gives savvy investors an opportunity. People often underestimate remarkable growth — so investors can make money when fast growth is not fully appreciated. 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.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.