The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how AudioCodes Ltd.'s (NASDAQ:AUDC) P/E ratio could help you assess the value on offer. What is AudioCodes's P/E ratio? Well, based on the last twelve months it is 44.09. That corresponds to an earnings yield of approximately 2.3%.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for AudioCodes:
P/E of 44.09 = $25.29 ÷ $0.57 (Based on the year to September 2019.)
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 necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
Does AudioCodes 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. As you can see below, AudioCodes has a higher P/E than the average company (20.4) in the communications industry.
That means that the market expects AudioCodes will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
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. Earnings growth means that in the future the 'E' will be higher. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
AudioCodes's earnings made like a rocket, taking off 73% last year. The cherry on top is that the five year growth rate was an impressive 69% per year. So I'd be surprised if the P/E ratio was not above average.
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. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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 AudioCodes's Balance Sheet Tell Us?
AudioCodes has net cash of US$64m. 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 AudioCodes's P/E Ratio
AudioCodes has a P/E of 44.1. That's higher than the average in its market, which is 18.9. Its net cash position is the cherry on top of its superb EPS growth. So based on this analysis we'd expect AudioCodes to have a high P/E ratio.
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 visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course you might be able to find a better stock than AudioCodes. So you may wish to see this free collection of other companies that have grown earnings strongly.
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.
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.