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 Freelance.com SA's (EPA:ALFRE) P/E ratio could help you assess the value on offer. Freelance.com has a price to earnings ratio of 14.73, based on the last twelve months. In other words, at today's prices, investors are paying €14.73 for every €1 in prior year profit.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Freelance.com:
P/E of 14.73 = €2.370 ÷ €0.161 (Based on the trailing twelve months to December 2019.)
(Note: the above calculation results may not be precise due to rounding.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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 Freelance.com 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 Freelance.com has a higher P/E than the average (9.6) P/E for companies in the professional services industry.
Its relatively high P/E ratio indicates that Freelance.com shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn't guarantee future growth. So further research is always essential. 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. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Freelance.com's 102% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. And earnings per share have improved by 59% annually, over the last three years. So we'd absolutely expect it to have a relatively high P/E ratio.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. So it won't reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
Freelance.com's Balance Sheet
Freelance.com has net cash of €15m. This is fairly high at 18% of its market capitalization. That might mean balance sheet strength is important to the business, but should also help push the P/E a bit higher than it would otherwise be.
The Verdict On Freelance.com's P/E Ratio
Freelance.com has a P/E of 14.7. That's around the same as the average in the FR market, which is 14.4. Its net cash position is the cherry on top of its superb EPS growth. So at a glance we're a bit surprised that Freelance.com does not have a higher P/E ratio.
Investors should be looking to buy stocks that the market is wrong about. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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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