The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll show how you can use VMware, Inc.'s (NYSE:VMW) P/E ratio to inform your assessment of the investment opportunity. VMware has a P/E ratio of 33.53, based on the last twelve months. That is equivalent to an earnings yield of about 3.0%.
How Do I Calculate VMware's Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for VMware:
P/E of 33.53 = $162.68 ÷ $4.85 (Based on the trailing twelve months to May 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 is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
How Does VMware's P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. We can see in the image below that the average P/E (49.6) for companies in the software industry is higher than VMware's P/E.
VMware's P/E tells us that market participants think it will not fare as well as its peers in the same industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. 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
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. When earnings grow, the 'E' increases, over time. And in that case, the P/E ratio itself will drop rather quickly. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
VMware increased earnings per share by a whopping 46% last year. And it has bolstered its earnings per share by 15% per year over the last five years. So we'd generally expect it to have a relatively high P/E ratio.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The 'Price' in P/E reflects the market capitalization of the company. So it won't reflect the advantage of cash, or disadvantage of debt. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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 VMware's P/E?
VMware has net debt worth just 1.4% of its market capitalization. The market might award it a higher P/E ratio if it had net cash, but its unlikely this low level of net borrowing is having a big impact on the P/E multiple.
The Verdict On VMware's P/E Ratio
VMware has a P/E of 33.5. That's higher than the average in its market, which is 17.5. While the company does use modest debt, its recent earnings growth is superb. So to be frank we are not surprised it has a high P/E ratio.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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.
You might be able to find a better buy than VMware. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
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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. Thank you for reading.