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 Eagle Pharmaceuticals, Inc.'s (NASDAQ:EGRX) P/E ratio could help you assess the value on offer. Eagle Pharmaceuticals has a price to earnings ratio of 19.02, based on the last twelve months. In other words, at today's prices, investors are paying $19.02 for every $1 in prior year profit.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Eagle Pharmaceuticals:
P/E of 19.02 = $56.42 ÷ $2.97 (Based on the year to June 2019.)
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 is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
Does Eagle Pharmaceuticals Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. As you can see below, Eagle Pharmaceuticals has a higher P/E than the average company (17.4) in the biotechs industry.
Eagle Pharmaceuticals's P/E tells us that market participants think the company will perform better than its industry peers, going forward. 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
P/E ratios primarily reflect market expectations around earnings growth rates. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.
Notably, Eagle Pharmaceuticals grew EPS by a whopping 48% in the last year. And it has improved its earnings per share by 142% per year over the last three years. So we'd generally expect it to have a relatively high P/E ratio.
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. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its 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.
How Does Eagle Pharmaceuticals's Debt Impact Its P/E Ratio?
Since Eagle Pharmaceuticals holds net cash of US$67m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Eagle Pharmaceuticals's P/E Ratio
Eagle Pharmaceuticals trades on a P/E ratio of 19.0, which is above its market average of 17.5. Its net cash position is the cherry on top of its superb EPS growth. So based on this analysis we'd expect Eagle Pharmaceuticals to have a high P/E ratio.
When the market is wrong about a stock, it gives savvy investors an opportunity. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
You might be able to find a better buy than Eagle Pharmaceuticals. 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 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.