The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at OptiComm Ltd's (ASX:OPC) P/E ratio and reflect on what it tells us about the company's share price. OptiComm has a price to earnings ratio of 19.19, based on the last twelve months. In other words, at today's prices, investors are paying A$19.19 for every A$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 OptiComm:
P/E of 19.19 = AUD3.98 ÷ AUD0.21 (Based on the trailing twelve months to June 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each AUD1 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 OptiComm's P/E Ratio Compare To Its Peers?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. The image below shows that OptiComm has a lower P/E than the average (32.1) P/E for companies in the telecom industry.
OptiComm's P/E tells us that market participants think it will not fare as well as its peers in the same industry. 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. And in that case, the P/E ratio itself will drop rather quickly. Then, a lower P/E should attract more buyers, pushing the share price up.
OptiComm increased earnings per share by 6.1% last year. And earnings per share have improved by 22% annually, over the last five years.
Remember: P/E Ratios Don't Consider The Balance Sheet
The 'Price' in P/E reflects the market capitalization of the company. That means it doesn't take debt or cash into account. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
OptiComm's Balance Sheet
Since OptiComm holds net cash of AU$9.7m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On OptiComm's P/E Ratio
OptiComm has a P/E of 19.2. That's around the same as the average in the AU market, which is 18.9. Earnings improved over the last year. And the net cash position gives the company many options. The average P/E suggests the market isn't overly optimistic, though.
Investors have an opportunity when market expectations about a stock are wrong. 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.
You might be able to find a better buy than OptiComm. 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.
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.