Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use Laboratorios Farmaceuticos Rovi, S.A.'s (BME:ROVI) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Laboratorios Farmaceuticos Rovi's P/E ratio is 40.37. That means that at current prices, buyers pay €40.37 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 = Share Price ÷ Earnings per Share (EPS)
Or for Laboratorios Farmaceuticos Rovi:
P/E of 40.37 = €24.00 ÷ €0.59 (Based on the trailing twelve months 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. 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.
How Does Laboratorios Farmaceuticos Rovi's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (22.4) for companies in the pharmaceuticals industry is lower than Laboratorios Farmaceuticos Rovi's P/E.
That means that the market expects Laboratorios Farmaceuticos Rovi will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.
Laboratorios Farmaceuticos Rovi's 123% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won't reflect the advantage of cash, or disadvantage of debt. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
So What Does Laboratorios Farmaceuticos Rovi's Balance Sheet Tell Us?
The extra options and safety that comes with Laboratorios Farmaceuticos Rovi's €20m 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 Laboratorios Farmaceuticos Rovi's P/E Ratio
Laboratorios Farmaceuticos Rovi's P/E is 40.4 which is above average (16.9) in its market. The excess cash it carries is the gravy on top its fast EPS growth. So based on this analysis we'd expect Laboratorios Farmaceuticos Rovi to have a high P/E ratio.
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 visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course you might be able to find a better stock than Laboratorios Farmaceuticos Rovi. So you may wish to see this free collection of other companies that have grown earnings strongly.
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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