This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we'll show how First Derivatives plc's (LON:FDP) P/E ratio could help you assess the value on offer. First Derivatives has a price to earnings ratio of 51.75, based on the last twelve months. That is equivalent to an earnings yield of about 1.9%.
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 51.75 = £27.40 ÷ £0.53 (Based on the year to August 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.
Does First Derivatives 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. The image below shows that First Derivatives has a higher P/E than the average (31.3) P/E for companies in the software industry.
Its relatively high P/E ratio indicates that First Derivatives shareholders think it will perform better than other companies in its industry classification. Clearly the market expects growth, but it isn't guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
How Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. Earnings growth means that in the future the 'E' will be higher. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
It's great to see that First Derivatives grew EPS by 17% in the last year. And it has bolstered its earnings per share by 8.5% per year over the last five years. So one might expect an above average 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. 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.
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.
First Derivatives's Balance Sheet
First Derivatives has net debt worth just 8.1% of its market capitalization. So it doesn't have as many options as it would with net cash, but its debt would not have much of an impact on its P/E ratio.
The Bottom Line On First Derivatives's P/E Ratio
First Derivatives trades on a P/E ratio of 51.8, which is above its market average of 18.3. Its debt levels do not imperil its balance sheet and it is growing EPS strongly. Therefore, it's not particularly surprising that it has a above average P/E ratio.
Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
You might be able to find a better buy than First Derivatives. 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).
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.
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