The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how Vicor Corporation's (NASDAQ:VICR) P/E ratio could help you assess the value on offer. Vicor has a price to earnings ratio of 45.79, based on the last twelve months. In other words, at today's prices, investors are paying $45.79 for every $1 in prior year profit.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Vicor:
P/E of 45.79 = $30.49 ÷ $0.67 (Based on the trailing twelve months to June 2019.)
Is A High Price-to-Earnings Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. 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 Does Vicor's P/E Ratio Compare To Its Peers?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. As you can see below, Vicor has a much higher P/E than the average company (14.6) in the electrical industry.
Vicor's P/E tells us that market participants think the company will perform better than its industry peers, going forward. 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
Earnings growth rates have a big influence on P/E ratios. When earnings grow, the 'E' increases, over time. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Vicor's earnings made like a rocket, taking off 96% last year.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
So What Does Vicor's Balance Sheet Tell Us?
Vicor has net cash of US$71m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Verdict On Vicor's P/E Ratio
Vicor has a P/E of 45.8. That's higher than the average in its market, which is 17.3. Its net cash position is the cherry on top of its superb EPS growth. So based on this analysis we'd expect Vicor to have a high P/E ratio.
When the market is wrong about a stock, it gives savvy investors an opportunity. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine.' 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.
But note: Vicor may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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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. Thank you for reading.