This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we'll show how NetApp, Inc.'s (NASDAQ:NTAP) P/E ratio could help you assess the value on offer. NetApp has a price to earnings ratio of 12.06, based on the last twelve months. That means that at current prices, buyers pay $12.06 for every $1 in trailing yearly profits.
How Do You Calculate NetApp's P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for NetApp:
P/E of 12.06 = $48.06 ÷ $3.98 (Based on the year to July 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 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.
Does NetApp 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. If you look at the image below, you can see NetApp has a lower P/E than the average (18) in the tech industry classification.
NetApp's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Since the market seems unimpressed with NetApp, it's quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. Earnings growth means that in the future the 'E' will be higher. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.
NetApp's 298% 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. With that kind of growth rate we would generally expect a high P/E ratio.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
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. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
NetApp's Balance Sheet
With net cash of US$2.0b, NetApp has a very strong balance sheet, which may be important for its business. Having said that, at 17% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On NetApp's P/E Ratio
NetApp has a P/E of 12.1. That's below the average in the US market, which is 17.3. Not only should the net cash position reduce risk, but the recent growth has been impressive. The relatively low P/E ratio implies the market is pessimistic.
When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
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.
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