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 IRadimed Corporation's (NASDAQ:IRMD) P/E ratio could help you assess the value on offer. What is IRadimed's P/E ratio? Well, based on the last twelve months it is 31.45. That means that at current prices, buyers pay $31.45 for every $1 in trailing yearly profits.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for IRadimed:
P/E of 31.45 = $22.88 ÷ $0.73 (Based on the year to September 2019.)
Is A High Price-to-Earnings Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. 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 IRadimed 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. If you look at the image below, you can see IRadimed has a lower P/E than the average (46.7) in the medical equipment industry classification.
IRadimed'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 IRadimed, it's quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
IRadimed's 62% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. The sweetener is that the annual five year growth rate of 20% is also impressive. So I'd be surprised if the P/E ratio was not above average. Regrettably, the longer term performance is poor, with EPS down -20% per year over 3 years.
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. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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 IRadimed's Balance Sheet Tell Us?
With net cash of US$43m, IRadimed has a very strong balance sheet, which may be important for its business. Having said that, at 16% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Verdict On IRadimed's P/E Ratio
IRadimed trades on a P/E ratio of 31.4, which is above its market average of 18.5. The excess cash it carries is the gravy on top its fast EPS growth. So based on this analysis we'd expect IRadimed to have 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 IRadimed. 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).
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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