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 Microsoft Corporation's (NASDAQ:MSFT) P/E ratio to inform your assessment of the investment opportunity. What is Microsoft's P/E ratio? Well, based on the last twelve months it is 28.40. That means that at current prices, buyers pay $28.40 for every $1 in trailing yearly profits.
How Do You Calculate Microsoft's P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Microsoft:
P/E of 28.40 = $152.32 ÷ $5.36 (Based on the year to September 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Does Microsoft's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Microsoft has a lower P/E than the average (45.6) P/E for companies in the software industry.
Its relatively low P/E ratio indicates that Microsoft 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. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
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. That means even if the current P/E is high, it will reduce over time if the share price stays flat. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Microsoft's 119% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. The cherry on top is that the five year growth rate was an impressive 16% per year. So I'd be surprised if the P/E ratio was not above average.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The 'Price' in P/E reflects the market capitalization of the company. So it won't reflect the advantage of cash, or disadvantage of debt. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
So What Does Microsoft's Balance Sheet Tell Us?
The extra options and safety that comes with Microsoft's US$67b net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Bottom Line On Microsoft's P/E Ratio
Microsoft's P/E is 28.4 which is above average (18.4) in its market. Its net cash position is the cherry on top of its superb EPS growth. To us, this is the sort of company that we would expect to carry an above average price tag (relative to earnings).
Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. 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.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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.
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.