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Vanda Pharmaceuticals (NASDAQ:VNDA) shareholders are no doubt pleased to see that the share price has bounced 30% in the last month alone, although it is still down 13% over the last quarter. But shareholders may not all be feeling jubilant, since the share price is still down 31% in the last year.
All else being equal, a sharp share price increase should make a stock less attractive to potential investors. In the long term, share prices tend to follow earnings per share, but in the short term prices bounce around in response to short term factors (which are not always obvious). The implication here is that deep value investors might steer clear when expectations of a company are too high. Perhaps the simplest way to get a read on investors' expectations of a business is to look at its Price to Earnings Ratio (PE Ratio). Investors have optimistic expectations of companies with higher P/E ratios, compared to companies with lower P/E ratios.
Does Vanda Pharmaceuticals Have A Relatively High Or Low P/E For Its Industry?
Vanda Pharmaceuticals's P/E of 5.49 indicates relatively low sentiment towards the stock. We can see in the image below that the average P/E (17.8) for companies in the biotechs industry is higher than Vanda Pharmaceuticals's P/E.
Its relatively low P/E ratio indicates that Vanda Pharmaceuticals shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Vanda Pharmaceuticals, 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.
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.
In the last year, Vanda Pharmaceuticals grew EPS like Taylor Swift grew her fan base back in 2010; the 339% gain was both fast and well deserved. The sweetener is that the annual five year growth rate of 30% is also impressive. So I'd be surprised if the P/E ratio was not above average.
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. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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).
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.
Is Debt Impacting Vanda Pharmaceuticals's P/E?
With net cash of US$312m, Vanda Pharmaceuticals has a very strong balance sheet, which may be important for its business. Having said that, at 48% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On Vanda Pharmaceuticals's P/E Ratio
Vanda Pharmaceuticals has a P/E of 5.5. That's below the average in the US market, which is 13.5. Not only should the net cash position reduce risk, but the recent growth has been impressive. One might conclude that the market is a bit pessimistic, given the low P/E ratio. What we know for sure is that investors are becoming less uncomfortable about Vanda Pharmaceuticals's prospects, since they have pushed its P/E ratio from 4.2 to 5.5 over the last month. For those who like to invest in turnarounds, that might mean it's time to put the stock on a watchlist, or research it. But others might consider the opportunity to have passed.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course you might be able to find a better stock than Vanda Pharmaceuticals. So you may wish to see this free collection of other companies that have grown earnings strongly.
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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