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Should You Be Tempted To Sell First Derivatives plc (LON:FDP) Because Of Its P/E Ratio?

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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at First Derivatives plc's (LON:FDP) P/E ratio and reflect on what it tells us about the company's share price. First Derivatives has a price to earnings ratio of 66.86, based on the last twelve months. That means that at current prices, buyers pay £66.86 for every £1 in trailing yearly profits.

Check out our latest analysis for First Derivatives

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 First Derivatives:

P/E of 66.86 = £34 ÷ £0.51 (Based on the trailing twelve months to February 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 £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. When earnings grow, the 'E' increases, over time. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.

First Derivatives increased earnings per share by a whopping 26% last year. And earnings per share have improved by 8.1% annually, over the last five years. With that performance, I would expect it to have an above average P/E ratio.

Does First Derivatives 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. You can see in the image below that the average P/E (31.4) for companies in the software industry is lower than First Derivatives's P/E.

AIM:FDP Price Estimation Relative to Market, June 10th 2019

That means that the market expects First Derivatives will outperform other companies in its industry. Shareholders are clearly optimistic, but the future is always uncertain. So further research is always essential. I often monitor director buying and selling.

Remember: P/E Ratios Don't Consider The Balance Sheet

The 'Price' in P/E reflects the market capitalization of the company. So it won't reflect the advantage of cash, or disadvantage of debt. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.

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 First Derivatives's Debt Impact Its P/E Ratio?

First Derivatives's net debt is 1.8% of its market cap. The market might award it a higher P/E ratio if it had net cash, but its unlikely this low level of net borrowing is having a big impact on the P/E multiple.

The Bottom Line On First Derivatives's P/E Ratio

First Derivatives's P/E is 66.9 which suggests the market is more focussed on the future opportunity rather than the current level of earnings. The company is not overly constrained by its modest debt levels, and its recent EPS growth very solid. Therefore, it's not particularly surprising that it has a above average P/E ratio.

Investors have an opportunity when market expectations about a stock are wrong. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

But note: First Derivatives 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 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.