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Here's What FormFactor, Inc.'s (NASDAQ:FORM) P/E Ratio Is Telling Us

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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 FormFactor, Inc.'s (NASDAQ:FORM) P/E ratio to inform your assessment of the investment opportunity. FormFactor has a P/E ratio of 11.12, based on the last twelve months. In other words, at today's prices, investors are paying $11.12 for every $1 in prior year profit.

See our latest analysis for FormFactor

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 FormFactor:

P/E of 11.12 = $15.74 ÷ $1.42 (Based on the year to December 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. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. When earnings grow, the 'E' increases, over time. 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.

It's nice to see that FormFactor grew EPS by a stonking 152% in the last year. And its annual EPS growth rate over 5 years is 78%. So we'd generally expect it to have a relatively high P/E ratio.

How Does FormFactor's P/E Ratio Compare To Its Peers?

The P/E ratio indicates whether the market has higher or lower expectations of a company. We can see in the image below that the average P/E (18.6) for companies in the semiconductor industry is higher than FormFactor's P/E.

NasdaqGS:FORM Price Estimation Relative to Market, March 26th 2019
NasdaqGS:FORM Price Estimation Relative to Market, March 26th 2019

Its relatively low P/E ratio indicates that FormFactor shareholders think it will struggle to do as well as other companies in its industry classification. Many investors like to buy stocks when the market is pessimistic about their prospects. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

The 'Price' in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining cash).

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.

FormFactor's Balance Sheet

Since FormFactor holds net cash of US$84m, it can spend on growth, justifying a higher P/E ratio than otherwise.

The Bottom Line On FormFactor's P/E Ratio

FormFactor's P/E is 11.1 which is below average (17.2) 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.

Investors have an opportunity when market expectations about a stock are wrong. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free report on the analyst consensus forecasts could help you make a master move on this stock.

You might be able to find a better buy than FormFactor. 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 editorial-team@simplywallst.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.

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