Here's How P/E Ratios Can Help Us Understand Magic Software Enterprises Ltd. (NASDAQ:MGIC)
This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at Magic Software Enterprises Ltd.'s (NASDAQ:MGIC) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, Magic Software Enterprises has a P/E ratio of 26.42. That means that at current prices, buyers pay $26.42 for every $1 in trailing yearly profits.
Check out our latest analysis for Magic Software Enterprises
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 Magic Software Enterprises:
P/E of 26.42 = USD9.71 ÷ USD0.37 (Based on the trailing twelve months to September 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. 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'.
How Does Magic Software Enterprises's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Magic Software Enterprises has a lower P/E than the average (43.9) P/E for companies in the software industry.
Magic Software Enterprises'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 Magic Software Enterprises, 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
Earnings growth rates have a big influence on P/E ratios. When earnings grow, the 'E' increases, over time. That means unless the share price increases, the P/E will reduce in a few years. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Magic Software Enterprises shrunk earnings per share by 13% over the last year. But it has grown its earnings per share by 1.8% per year over the last three years. And over the longer term (5 years) earnings per share have decreased 2.5% annually. This might lead to muted expectations.
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. That means it doesn't take debt or cash into account. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
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.
Is Debt Impacting Magic Software Enterprises's P/E?
With net cash of US$67m, Magic Software Enterprises 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 Verdict On Magic Software Enterprises's P/E Ratio
Magic Software Enterprises has a P/E of 26.4. That's higher than the average in its market, which is 16.5. The recent drop in earnings per share might keep value investors away, but the healthy balance sheet means the company retains potential for future growth. If fails to eventuate, the current high P/E could prove to be temporary, as the share price falls.
Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
Of course you might be able to find a better stock than Magic Software Enterprises. 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 editorial-team@simplywallst.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.
