Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at Intelligent Systems Corporation's (NYSEMKT:INS) P/E ratio and reflect on what it tells us about the company's share price. What is Intelligent Systems's P/E ratio? Well, based on the last twelve months it is 47.83. That is equivalent to an earnings yield of about 2.1%.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Intelligent Systems:
P/E of 47.83 = $40.29 ÷ $0.84 (Based on the year to March 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. 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 Intelligent Systems's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. If you look at the image below, you can see Intelligent Systems has a lower P/E than the average (52.1) in the software industry classification.
This suggests that market participants think Intelligent Systems will underperform other companies in its industry. Since the market seems unimpressed with Intelligent Systems, 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Intelligent Systems's earnings made like a rocket, taking off 316% last year. The sweetener is that the annual five year growth rate of 70% is also impressive. With that kind of growth rate we would generally expect a high P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
The 'Price' in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
Intelligent Systems's Balance Sheet
The extra options and safety that comes with Intelligent Systems's US$22m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Bottom Line On Intelligent Systems's P/E Ratio
Intelligent Systems has a P/E of 47.8. That's higher than the average in its market, which is 17.9. The excess cash it carries is the gravy on top its fast EPS growth. To us, this is the sort of company that we would expect to carry an above average price tag (relative to earnings).
Investors have an opportunity when market expectations about a stock are wrong. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. We don't have analyst forecasts, but you could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.
But note: Intelligent Systems may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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.
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.