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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how Psychemedics Corporation's (NASDAQ:PMD) P/E ratio could help you assess the value on offer. Based on the last twelve months, Psychemedics's P/E ratio is 17.16. That means that at current prices, buyers pay $17.16 for every $1 in trailing yearly profits.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Psychemedics:
P/E of 17.16 = $14.3 ÷ $0.83 (Based on the year to December 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 is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
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. And in that case, the P/E ratio itself will drop rather quickly. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Psychemedics saw earnings per share decrease by 25% last year. But it has grown its earnings per share by 3.0% per year over the last five years.
Does Psychemedics Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio indicates whether the market has higher or lower expectations of a company. If you look at the image below, you can see Psychemedics has a lower P/E than the average (22.2) in the healthcare industry classification.
Its relatively low P/E ratio indicates that Psychemedics shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Psychemedics, 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
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. 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.
How Does Psychemedics's Debt Impact Its P/E Ratio?
Since Psychemedics holds net cash of US$6.3m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Psychemedics's P/E Ratio
Psychemedics's P/E is 17.2 which is about average (18.1) in the US market. Although the recent drop in earnings per share would keep the market cautious, the healthy balance sheet means the company retains potential for future growth. So it's not surprising to see it trade on a P/E roughly in line with the market.
Investors have an opportunity when market expectations about a stock are wrong. 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.' Although we don't have analyst forecasts, shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
But note: Psychemedics 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).
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 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. Thank you for reading.