Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how Lectra SA's (EPA:LSS) P/E ratio could help you assess the value on offer. Lectra has a P/E ratio of 23.82, based on the last twelve months. That is equivalent to an earnings yield of about 4.2%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Lectra:
P/E of 23.82 = EUR22.35 ÷ EUR0.94 (Based on the trailing twelve months 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 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 Lectra 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. The image below shows that Lectra has a lower P/E than the average (33.9) P/E for companies in the software industry.
Lectra's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Many investors like to buy stocks when the market is pessimistic about their prospects. You should delve deeper. I like to check if company insiders have been buying or selling.
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. 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.
Lectra had pretty flat EPS growth in the last year. But EPS is up 17% over the last 5 years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. 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 Lectra's Balance Sheet Tell Us?
With net cash of €102m, Lectra has a very strong balance sheet, which may be important for its business. Having said that, at 14% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On Lectra's P/E Ratio
Lectra trades on a P/E ratio of 23.8, which is above its market average of 18.3. Earnings improved over the last year. And the healthy balance sheet means the company can sustain growth while the P/E suggests shareholders think it will.
Investors should be looking to buy stocks that the market is wrong about. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course you might be able to find a better stock than Lectra. So you may wish to see this free collection of other companies that have grown earnings strongly.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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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