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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 Materion Corporation's (NYSE:MTRN) P/E ratio could help you assess the value on offer. Materion has a P/E ratio of 48.54, based on the last twelve months. In other words, at today's prices, investors are paying $48.54 for every $1 in prior year profit.
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 Materion:
P/E of 48.54 = $65.19 ÷ $1.34 (Based on the year to March 2019.)
Is A High P/E 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.'
How Growth Rates Impact P/E Ratios
If earnings fall then in the future the 'E' will be lower. 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.
Materion increased earnings per share by a whopping 43% last year. And earnings per share have improved by 6.4% annually, over the last five years. I'd therefore be a little surprised if its P/E ratio was not relatively high. In contrast, EPS has decreased by 1.9%, annually, over 3 years.
Does Materion Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. As you can see below, Materion has a much higher P/E than the average company (9.2) in the metals and mining industry.
That means that the market expects Materion will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So further research is always essential. I often monitor director buying and selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn't take debt or cash into account. 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 Materion's Balance Sheet Tell Us?
Since Materion holds net cash of US$19m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Materion's P/E Ratio
Materion has a P/E of 48.5. That's higher than the average in the US market, which is 17.6. Its net cash position is the cherry on top of its superb EPS growth. So based on this analysis we'd expect Materion to have a high P/E ratio.
Investors should be looking to buy stocks that the market is wrong about. 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 Materion. 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).
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.