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Why Analog Devices, Inc.’s (NASDAQ:ADI) High P/E Ratio Isn’t Necessarily A Bad Thing

Asher Wright

This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll look at Analog Devices, Inc.’s (NASDAQ:ADI) P/E ratio and reflect on what it tells us about the company’s share price. Analog Devices has a price to earnings ratio of 21.2, based on the last twelve months. That means that at current prices, buyers pay $21.2 for every $1 in trailing yearly profits.

See our latest analysis for Analog Devices

How Do I Calculate Analog Devices’s Price To Earnings Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for Analog Devices:

P/E of 21.2 = $85.24 ÷ $4.02 (Based on the year to November 2018.)

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 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

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.

Notably, Analog Devices grew EPS by a whopping 92% in the last year. And it has bolstered its earnings per share by 8.7% per year over the last five years. I’d therefore be a little surprised if its P/E ratio was not relatively high.

How Does Analog Devices’s P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Analog Devices has a higher P/E than the average (17.1) P/E for companies in the semiconductor industry.

NasdaqGS:ADI PE PEG Gauge January 9th 19

That means that the market expects Analog Devices will outperform other companies in its industry. Shareholders are clearly optimistic, but the future is always uncertain. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

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. 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 taking on debt (or spending its remaining 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 Analog Devices’s P/E?

Analog Devices’s net debt is 18% of its market cap. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.

The Verdict On Analog Devices’s P/E Ratio

Analog Devices’s P/E is 21.2 which is above average (16.7) in the US market. The company is not overly constrained by its modest debt levels, and it is growing earnings per share. So it is not surprising the market is probably extrapolating recent growth well into the future, reflected in the relatively high P/E ratio.

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.

Of course you might be able to find a better stock than Analog Devices. So you may wish to see this free collection of other companies that have grown earnings strongly.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.