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 Integrated Research Limited's (ASX:IRI) P/E ratio to inform your assessment of the investment opportunity. Looking at earnings over the last twelve months, Integrated Research has a P/E ratio of 24.73. That corresponds to an earnings yield of approximately 4.0%.
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 Integrated Research:
P/E of 24.73 = A$3.160 ÷ A$0.128 (Based on the trailing twelve months to December 2019.)
(Note: the above calculation results may not be precise due to rounding.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each A$1 of company earnings. 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.
Does Integrated Research Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. If you look at the image below, you can see Integrated Research has a lower P/E than the average (34.2) in the software industry classification.
Its relatively low P/E ratio indicates that Integrated Research shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Integrated Research, it's quite possible it could surprise on the upside. If you consider the stock interesting, further research is recommended. For example, 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. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Integrated Research's earnings per share were pretty steady over the last year. But over the longer term (5 years) earnings per share have increased by 13%.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
The 'Price' in P/E reflects the market capitalization of the company. That means it doesn't take debt or cash into account. 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.
Is Debt Impacting Integrated Research's P/E?
Integrated Research has net cash of AU$7.6m. 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 Integrated Research's P/E Ratio
Integrated Research has a P/E of 24.7. That's higher than the average in its market, which is 14.7. Recent earnings growth wasn't bad. Also positive, the relatively strong balance sheet will allow for investment in growth -- and the P/E indicates shareholders that will happen!
Investors have an opportunity when market expectations about a stock are wrong. 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.
You might be able to find a better buy than Integrated Research. 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).
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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. Thank you for reading.