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 Alfa Financial Software Holdings PLC's (LON:ALFA) P/E ratio to inform your assessment of the investment opportunity. What is Alfa Financial Software Holdings's P/E ratio? Well, based on the last twelve months it is 13.19. In other words, at today's prices, investors are paying £13.19 for every £1 in prior year profit.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Alfa Financial Software Holdings:
P/E of 13.19 = £0.84 ÷ £0.063 (Based on the trailing twelve months to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each £1 the company has earned over the last year. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.
How Does Alfa Financial Software Holdings's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Alfa Financial Software Holdings has a lower P/E than the average (30.4) P/E for companies in the software industry.
Its relatively low P/E ratio indicates that Alfa Financial Software Holdings shareholders think it will struggle to do as well as other companies in its industry classification. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. 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.
Alfa Financial Software Holdings saw earnings per share decrease by 31% last year. And over the longer term (5 years) earnings per share have decreased 59% annually. This might lead to muted expectations.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. So it won't reflect the advantage of cash, or disadvantage of debt. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
Is Debt Impacting Alfa Financial Software Holdings's P/E?
Alfa Financial Software Holdings has net cash of UK£45m. This is fairly high at 18% of its market capitalization. That might mean balance sheet strength is important to the business, but should also help push the P/E a bit higher than it would otherwise be.
The Bottom Line On Alfa Financial Software Holdings's P/E Ratio
Alfa Financial Software Holdings's P/E is 13.2 which is below average (16) in the GB market. The recent drop in earnings per share would almost certainly temper expectations, the healthy balance sheet means the company retains potential for future growth. If that occurs, the current low P/E could prove to be temporary.
When the market is wrong about a stock, it gives savvy investors an opportunity. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. 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: Alfa Financial Software Holdings 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).
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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.