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This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We’ll show how you can use Frontier Developments plc’s (LON:FDEV) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Frontier Developments’s P/E ratio is 20.82. In other words, at today’s prices, investors are paying £20.82 for every £1 in prior year profit.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Frontier Developments:
P/E of 20.82 = £8.72 ÷ £0.42 (Based on the trailing twelve months to November 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each £1 of company earnings. All else being equal, it’s better to pay a low price — but as Warren Buffett said, ‘It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.’
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. 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.
Notably, Frontier Developments grew EPS by a whopping 111% in the last year. And it has bolstered its earnings per share by 58% per year over the last five years. I’d therefore be a little surprised if its P/E ratio was not relatively high.
How Does Frontier Developments’s P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Frontier Developments has a P/E ratio that is roughly in line with the entertainment industry average (19.5).
Frontier Developments’s P/E tells us that market participants think its prospects are roughly in line with its industry. The company could surprise by performing better than average, in the future. 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.
Frontier Developments’s Balance Sheet
The extra options and safety that comes with Frontier Developments’s UK£39m 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 Frontier Developments’s P/E Ratio
Frontier Developments has a P/E of 20.8. That’s higher than the average in the GB market, which is 16. With cash in the bank the company has plenty of growth options — and it is already on the right track. So it does not seem strange that the P/E is above average.
When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
Of course you might be able to find a better stock than Frontier Developments. So you may wish to see this free collection of other companies that have grown earnings strongly.
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.