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 DocCheck AG's (ETR:AJ91) P/E ratio could help you assess the value on offer. Based on the last twelve months, DocCheck's P/E ratio is 18.86. In other words, at today's prices, investors are paying €18.86 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 DocCheck:
P/E of 18.86 = €8.6 ÷ €0.46 (Based on the trailing twelve months to December 2018.)
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.
Does DocCheck Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. The image below shows that DocCheck has a higher P/E than the average (12.9) P/E for companies in the healthcare services industry.
DocCheck's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Shareholders are clearly optimistic, but the future is always uncertain. So further research is always essential. I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
If earnings fall then in the future the 'E' will be lower. That means unless the share price falls, the P/E will increase in a few years. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
DocCheck saw earnings per share decrease by 5.7% last year. But EPS is up 16% over the last 5 years. And it has shrunk its earnings per share by 7.6% per year over the last three years. This growth rate might warrant a low P/E ratio. So we might expect a relatively low P/E.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
Don't forget that the P/E ratio considers market capitalization. That means it doesn't take debt or cash into account. 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.
How Does DocCheck's Debt Impact Its P/E Ratio?
With net cash of €10m, DocCheck has a very strong balance sheet, which may be important for its business. Having said that, at 24% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On DocCheck's P/E Ratio
DocCheck trades on a P/E ratio of 18.9, which is fairly close to the DE market average of 18.5. While the lack of recent growth is probably muting optimism, the healthy balance sheet means the company retains potential for future growth. So it's not surprising to see it trade on a P/E roughly in line with the market.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. We don't have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than DocCheck. 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).
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 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. Thank you for reading.