Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use Nova Measuring Instruments Ltd.'s (NASDAQ:NVMI) P/E ratio to inform your assessment of the investment opportunity. What is Nova Measuring Instruments's P/E ratio? Well, based on the last twelve months it is 27.44. That means that at current prices, buyers pay $27.44 for every $1 in trailing yearly profits.
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 Nova Measuring Instruments:
P/E of 27.44 = $37.20 ÷ $1.36 (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 $1 of company earnings. 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 Nova Measuring Instruments's P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. We can see in the image below that the average P/E (33.7) for companies in the semiconductor industry is higher than Nova Measuring Instruments's P/E.
Nova Measuring Instruments'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 Nova Measuring Instruments, it's quite possible it could surprise on the upside. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and 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. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. And in that case, the P/E ratio itself will drop rather quickly. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Nova Measuring Instruments saw earnings per share decrease by 20% last year. But over the longer term (5 years) earnings per share have increased by 15%.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. Thus, the metric does not reflect cash or debt held by the company. 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 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.
So What Does Nova Measuring Instruments's Balance Sheet Tell Us?
With net cash of US$179m, Nova Measuring Instruments 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 Nova Measuring Instruments's P/E Ratio
Nova Measuring Instruments trades on a P/E ratio of 27.4, which is above its market average of 18.7. The recent drop in earnings per share would make some investors cautious, but the healthy balance sheet means the company retains potential for future growth. If fails to eventuate, the current high P/E could prove to be temporary, as the share price falls.
Investors have an opportunity when market expectations about a stock are wrong. 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 report on the analyst consensus forecasts could help you make a master move on this stock.
You might be able to find a better buy than Nova Measuring Instruments. 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).
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.
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