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Is Prevas AB's (STO:PREV B) High P/E Ratio A Problem For Investors?

Simply Wall St

Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at Prevas AB's (STO:PREV B) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, Prevas has a P/E ratio of 27.65. In other words, at today's prices, investors are paying SEK27.65 for every SEK1 in prior year profit.

View our latest analysis for Prevas

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for Prevas:

P/E of 27.65 = SEK26.2 ÷ SEK0.95 (Based on the year to June 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each SEK1 the company has earned over the last year. 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.'

Does Prevas Have A Relatively High Or Low P/E For Its Industry?

One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. As you can see below, Prevas has a higher P/E than the average company (16.3) in the it industry.

OM:PREV B Price Estimation Relative to Market, July 22nd 2019

That means that the market expects Prevas will outperform other companies in its industry. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should delve deeper. I like to check if company insiders have been buying or selling.

How Growth Rates Impact P/E Ratios

Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. When earnings grow, the 'E' increases, over time. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.

Prevas shrunk earnings per share by 7.6% last year.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

Don't forget that the P/E ratio considers market capitalization. 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.

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.

How Does Prevas's Debt Impact Its P/E Ratio?

Prevas has net debt worth 25% of its market capitalization. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.

The Bottom Line On Prevas's P/E Ratio

Prevas's P/E is 27.7 which is above average (16.2) in its market. With modest debt but no EPS growth in the last year, it's fair to say the P/E implies some optimism about future earnings, from the market.

When the market is wrong about a stock, it gives savvy investors an opportunity. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. We don't have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.

You might be able to find a better buy than Prevas. 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 editorial-team@simplywallst.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.