U.S. Markets close in 4 hrs 52 mins

Despite Its High P/E Ratio, Is Power Integrations, Inc. (NASDAQ:POWI) Still Undervalued?

Simply Wall St

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 apply a basic P/E ratio analysis to Power Integrations, Inc.'s (NASDAQ:POWI), to help you decide if the stock is worth further research. Looking at earnings over the last twelve months, Power Integrations has a P/E ratio of 36.92. In other words, at today's prices, investors are paying $36.92 for every $1 in prior year profit.

View our latest analysis for Power Integrations

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 Power Integrations:

P/E of 36.92 = $79.56 ÷ $2.15 (Based on the trailing twelve months to March 2019.)

Is A High Price-to-Earnings Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.

How Growth Rates Impact P/E Ratios

Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.

Power Integrations's 131% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. Having said that, if we look back three years, EPS growth has averaged a comparatively less impressive 13%.

How Does Power Integrations'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. You can see in the image below that the average P/E (21.3) for companies in the semiconductor industry is lower than Power Integrations's P/E.

NasdaqGS:POWI Price Estimation Relative to Market, May 3rd 2019

Power Integrations's P/E tells us that market participants think the company will perform better than its industry peers, going forward. 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. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).

Is Debt Impacting Power Integrations's P/E?

Power Integrations has net cash of US$212m. 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 Power Integrations's P/E Ratio

Power Integrations's P/E is 36.9 which is above average (18.1) in the US market. The excess cash it carries is the gravy on top its fast EPS growth. So based on this analysis we'd expect Power Integrations to have a 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 report on the analyst consensus forecasts could help you make a master move on this stock.

But note: Power Integrations 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.