This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll look at Micro Focus International plc’s (LON:MCRO) P/E ratio and reflect on what it tells us about the company’s share price. Micro Focus International has a price to earnings ratio of 8.08, based on the last twelve months. That corresponds to an earnings yield of approximately 12%.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)
Or for Micro Focus International:
P/E of 8.08 = $16.05 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $1.99 (Based on the year to April 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each £1 the company has earned over the last year. 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 Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the ‘E’ will be higher. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
Micro Focus International increased earnings per share by a whopping 167% last year. And its annual EPS growth rate over 5 years is 4.5%. So we’d generally expect it to have a relatively high P/E ratio.
How Does Micro Focus International’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 Micro Focus International has a lower P/E than the average (24.4) in the software industry classification.
Its relatively low P/E ratio indicates that Micro Focus International shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Micro Focus International, it’s quite possible it could surprise on the upside. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
Remember: P/E Ratios Don’t Consider The Balance Sheet
Don’t forget that the P/E ratio considers market capitalization. That means it doesn’t take debt or cash into account. 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).
Micro Focus International’s Balance Sheet
Net debt totals 64% of Micro Focus International’s market cap. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.
The Verdict On Micro Focus International’s P/E Ratio
Micro Focus International trades on a P/E ratio of 8.1, which is below the GB market average of 16.2. The company may have significant debt, but EPS growth was good last year. If it continues to grow, then the current low P/E may prove to be unjustified.
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 report on the analyst consensus forecasts could help you make a master move on this stock.
But note: Micro Focus International 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).
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.