This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll look at Korn Ferry's (NYSE:KFY) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, Korn Ferry has a P/E ratio of 13.33. In other words, at today's prices, investors are paying $13.33 for every $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 = Price per Share ÷ Earnings per Share (EPS)
Or for Korn Ferry:
P/E of 13.33 = USD43.38 ÷ USD3.25 (Based on the trailing twelve months to October 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 USD1 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 Korn Ferry'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. We can see in the image below that the average P/E (20.6) for companies in the professional services industry is higher than Korn Ferry's P/E.
Korn Ferry'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 Korn Ferry, it's quite possible it could surprise on the upside. 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. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Korn Ferry's 140% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. And earnings per share have improved by 99% annually, over the last three years. So you might say it really deserves to have an above-average P/E ratio.
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. So it won't reflect the advantage of cash, or disadvantage of debt. 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).
While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
Korn Ferry's Balance Sheet
Since Korn Ferry holds net cash of US$193m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Korn Ferry's P/E Ratio
Korn Ferry trades on a P/E ratio of 13.3, which is below the US market average of 19.0. It grew its EPS nicely over the last year, and the healthy balance sheet implies there is more potential for growth. The below average P/E ratio suggests that market participants don't believe the strong growth will continue.
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 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.
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