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 PC Connection, Inc.’s (NASDAQ:CNXN) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, PC Connection’s P/E ratio is 15.75. That corresponds to an earnings yield of approximately 6.3%.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for PC Connection:
P/E of 15.75 = $38.08 ÷ $2.42 (Based on the trailing twelve months to December 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn’t a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business’s prospects, relative to stocks with a lower P/E.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. 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.
It’s great to see that PC Connection grew EPS by 18% in the last year. And its annual EPS growth rate over 5 years is 9.8%. This could arguably justify a relatively high P/E ratio.
How Does PC Connection’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 (19.7) for companies in the electronic industry is higher than PC Connection’s P/E.
PC Connection’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. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
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. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining cash).
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.
PC Connection’s Balance Sheet
The extra options and safety that comes with PC Connection’s US$92m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Verdict On PC Connection’s P/E Ratio
PC Connection has a P/E of 15.8. That’s below the average in the US market, which is 17.5. Not only should the net cash position reduce risk, but the recent growth has been impressive. The relatively low P/E ratio implies the market is pessimistic.
Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
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.
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 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. Thank you for reading.