Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how Illumina, Inc.'s (NASDAQ:ILMN) P/E ratio could help you assess the value on offer. What is Illumina's P/E ratio? Well, based on the last twelve months it is 46.23. That corresponds to an earnings yield of approximately 2.2%.
How Do You Calculate Illumina's P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Illumina:
P/E of 46.23 = $305.99 ÷ $6.62 (Based on the year to September 2019.)
Is A High P/E Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. 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.
Does Illumina Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. You can see in the image below that the average P/E (33.4) for companies in the life sciences industry is lower than Illumina's P/E.
That means that the market expects Illumina will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. Earnings growth means that in the future the 'E' will be higher. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Illumina increased earnings per share by a whopping 42% last year. And earnings per share have improved by 25% annually, over the last five years. So we'd generally expect it to have a relatively high P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
So What Does Illumina's Balance Sheet Tell Us?
Illumina has net cash of US$2.0b. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Bottom Line On Illumina's P/E Ratio
Illumina's P/E is 46.2 which is above average (18.2) in its market. The excess cash it carries is the gravy on top its fast EPS growth. To us, this is the sort of company that we would expect to carry an above average price tag (relative to earnings).
Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
You might be able to find a better buy than Illumina. 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).
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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. Thank you for reading.