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 Absolute Software Corporation's (TSE:ABT), to help you decide if the stock is worth further research. Based on the last twelve months, Absolute Software's P/E ratio is 27.18. In other words, at today's prices, investors are paying CA$27.18 for every CA$1 in prior year profit.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for Absolute Software:
P/E of 27.18 = CA$6.44 (Note: this is the share price in the reporting currency, namely, USD ) ÷ CA$0.24 (Based on the year to September 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each CA$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.
Does Absolute Software 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. You can see in the image below that the average P/E (18.3) for companies in the software industry is lower than Absolute Software's P/E.
That means that the market expects Absolute Software will outperform other companies in its industry. The market is optimistic about the future, but that doesn't guarantee future growth. 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. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.
In the last year, Absolute Software grew EPS like Taylor Swift grew her fan base back in 2010; the 111% gain was both fast and well deserved. The cherry on top is that the five year growth rate was an impressive 30% per year. So I'd be surprised if the P/E ratio was not above average.
Remember: P/E Ratios Don't Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won't reflect the advantage of cash, or disadvantage of debt. 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.
How Does Absolute Software's Debt Impact Its P/E Ratio?
With net cash of US$39m, Absolute Software has a very strong balance sheet, which may be important for its business. Having said that, at 14% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Verdict On Absolute Software's P/E Ratio
Absolute Software's P/E is 27.2 which is above average (15.5) in its market. The excess cash it carries is the gravy on top its fast EPS growth. So based on this analysis we'd expect Absolute Software to have a high P/E ratio.
When the market is wrong about a stock, it gives savvy investors an opportunity. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine. 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: Absolute Software 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).
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.
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.