The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how ScanSource, Inc.'s (NASDAQ:SCSC) P/E ratio could help you assess the value on offer. Based on the last twelve months, ScanSource's P/E ratio is 17.83. That means that at current prices, buyers pay $17.83 for every $1 in trailing yearly profits.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for ScanSource:
P/E of 17.83 = $38.13 ÷ $2.14 (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. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
Does ScanSource Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. If you look at the image below, you can see ScanSource has a lower P/E than the average (20.9) in the electronic industry classification.
This suggests that market participants think ScanSource will underperform other companies in its industry. Since the market seems unimpressed with ScanSource, 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
If earnings fall then in the future the 'E' will be lower. That means even if the current P/E is low, it will increase over time if the share price stays flat. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.
Notably, ScanSource grew EPS by a whopping 26% in the last year. Unfortunately, earnings per share are down 5.7% a year, over 5 years.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. 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.
How Does ScanSource's Debt Impact Its P/E Ratio?
ScanSource has net debt equal to 36% of its market cap. While that's enough to warrant consideration, it doesn't really concern us.
The Verdict On ScanSource's P/E Ratio
ScanSource has a P/E of 17.8. That's around the same as the average in the US market, which is 18.6. Given it has reasonable debt levels, and grew earnings strongly last year, the P/E indicates the market has doubts this growth can be sustained. Given analysts are expecting further growth, one might have expected a higher P/E ratio. That may be worth further research.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
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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