This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to FormFactor, Inc.'s (NASDAQ:FORM), to help you decide if the stock is worth further research. Based on the last twelve months, FormFactor's P/E ratio is 18.72. That corresponds to an earnings yield of approximately 5.3%.
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 FormFactor:
P/E of 18.72 = $26.55 ÷ $1.42 (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 is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
How Does FormFactor's P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. We can see in the image below that the average P/E (33.6) for companies in the semiconductor industry is higher than FormFactor's P/E.
This suggests that market participants think FormFactor will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You 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. 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. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
FormFactor's earnings made like a rocket, taking off 322% last year. And earnings per share have improved by 120% annually, over the last three years. So you might say it really deserves to have an above-average P/E ratio.
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. So it won't reflect the advantage of cash, or disadvantage of debt. 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).
How Does FormFactor's Debt Impact Its P/E Ratio?
The extra options and safety that comes with FormFactor's US$154m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Verdict On FormFactor's P/E Ratio
FormFactor trades on a P/E ratio of 18.7, which is fairly close to the US market average of 18.8. Its net cash position is the cherry on top of its superb EPS growth. So based on this analysis we'd expect FormFactor to have a higher P/E ratio.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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.
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