This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll show how you can use Synopsys, Inc.'s (NASDAQ:SNPS) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Synopsys's P/E ratio is 37.05. That is equivalent to an earnings yield of about 2.7%.
How Do I Calculate Synopsys's Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Synopsys:
P/E of 37.05 = $131.61 ÷ $3.55 (Based on the year to October 2019.)
Is A High P/E 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. 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 Synopsys's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. We can see in the image below that the average P/E (44.6) for companies in the software industry is higher than Synopsys's P/E.
Synopsys'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 Synopsys, 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. Earnings growth means that in the future the 'E' will be higher. 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.
Synopsys increased earnings per share by an impressive 22% over the last twelve months. And its annual EPS growth rate over 5 years is 16%. This could arguably justify a relatively high P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. 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.
So What Does Synopsys's Balance Sheet Tell Us?
Since Synopsys holds net cash of US$591m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Synopsys's P/E Ratio
Synopsys's P/E is 37.1 which is above average (18.7) in its market. Its net cash position supports a higher P/E ratio, as does its solid recent earnings growth. So it does not seem strange that the P/E is above average.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
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 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.
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