This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Taro Pharmaceutical Industries Ltd.'s (NYSE:TARO), to help you decide if the stock is worth further research. Taro Pharmaceutical Industries has a price to earnings ratio of 10.27, based on the last twelve months. That is equivalent to an earnings yield of about 9.7%.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Taro Pharmaceutical Industries:
P/E of 10.27 = $74.29 ÷ $7.23 (Based on the year to June 2019.)
Is A High P/E Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. 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.
Does Taro Pharmaceutical Industries Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. If you look at the image below, you can see Taro Pharmaceutical Industries has a lower P/E than the average (16.2) in the pharmaceuticals industry classification.
This suggests that market participants think Taro Pharmaceutical Industries will underperform other companies in its industry. Since the market seems unimpressed with Taro Pharmaceutical Industries, it's quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
If earnings fall then in the future the 'E' will be lower. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.
Taro Pharmaceutical Industries increased earnings per share by a whopping 29% last year. Unfortunately, earnings per share are down 1.9% a year, over 5 years.
Remember: P/E Ratios Don't Consider The Balance Sheet
Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
So What Does Taro Pharmaceutical Industries's Balance Sheet Tell Us?
With net cash of US$1.1b, Taro Pharmaceutical Industries has a very strong balance sheet, which may be important for its business. Having said that, at 40% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Verdict On Taro Pharmaceutical Industries's P/E Ratio
Taro Pharmaceutical Industries's P/E is 10.3 which is below average (17.5) in the US market. It grew its EPS nicely over the last year, and the healthy balance sheet implies there is more potential for growth. The relatively low P/E ratio implies the market is pessimistic.
When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. 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.
But note: Taro Pharmaceutical Industries 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).
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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.