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 Tower Semiconductor Ltd.'s (NASDAQ:TSEM) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Tower Semiconductor's P/E ratio is 16.38. That corresponds to an earnings yield of approximately 6.1%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Tower Semiconductor:
P/E of 16.38 = $18.73 ÷ $1.14 (Based on the year to June 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 isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
Does Tower Semiconductor Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. We can see in the image below that the average P/E (26.6) for companies in the semiconductor industry is higher than Tower Semiconductor's P/E.
Its relatively low P/E ratio indicates that Tower Semiconductor shareholders think it will struggle to do as well as other companies in its industry classification. Many investors like to buy stocks when the market is pessimistic about their prospects. 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. That means even if the current P/E is low, it will increase over time if the share price stays flat. Then, a higher P/E might scare off shareholders, pushing the share price down.
Tower Semiconductor's earnings per share fell by 58% in the last twelve months. And over the longer term (3 years) earnings per share have decreased 13% annually. This could justify a low P/E.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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).
Tower Semiconductor's Balance Sheet
With net cash of US$414m, Tower Semiconductor has a very strong balance sheet, which may be important for its business. Having said that, at 21% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Verdict On Tower Semiconductor's P/E Ratio
Tower Semiconductor trades on a P/E ratio of 16.4, which is fairly close to the US market average of 17. While the absence of growth in the last year is probably causing a degree of pessimism, the relatively strong balance sheet will allow the company to weather a storm; so it isn't very surprising to see that it has a P/E ratio close to the market average.
Investors should be looking to buy stocks that the market is wrong about. 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 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 be able to find a better stock than Tower Semiconductor. So you may wish to see this free collection of other companies that have grown earnings strongly.
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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.