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This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we'll show how Diamond Hill Investment Group, Inc.'s (NASDAQ:DHIL) P/E ratio could help you assess the value on offer. Based on the last twelve months, Diamond Hill Investment Group's P/E ratio is 9.55. In other words, at today's prices, investors are paying $9.55 for every $1 in prior year profit.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Diamond Hill Investment Group:
P/E of 9.55 = $139.52 ÷ $14.6 (Based on the trailing twelve months to March 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 is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
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. When earnings grow, the 'E' increases, over time. That means unless the share price increases, the P/E will reduce in a few years. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Diamond Hill Investment Group's earnings per share were pretty steady over the last year. But over the longer term (5 years) earnings per share have increased by 15%.
Does Diamond Hill Investment Group 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 Diamond Hill Investment Group has a lower P/E than the average (35.8) P/E for companies in the capital markets industry.
Diamond Hill Investment Group'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.
Remember: P/E Ratios Don't Consider The Balance Sheet
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 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.
Diamond Hill Investment Group's Balance Sheet
With net cash of US$82m, Diamond Hill Investment Group has a very strong balance sheet, which may be important for its business. Having said that, at 18% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Verdict On Diamond Hill Investment Group's P/E Ratio
Diamond Hill Investment Group's P/E is 9.6 which is below average (17.5) in the US market. EPS was up modestly better over the last twelve months. And the net cash position gives the company many options. So it's strange that the low P/E indicates low expectations.
Investors have an opportunity when market expectations about a stock are wrong. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. We don't have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.
Of course you might be able to find a better stock than Diamond Hill Investment Group. So you may wish to see this free collection of other companies that have grown earnings strongly.
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.
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. Thank you for reading.