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This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to DocCheck AG's (FRA:AJ91), to help you decide if the stock is worth further research. DocCheck has a price to earnings ratio of 19.63, based on the last twelve months. That corresponds to an earnings yield of approximately 5.1%.

See our latest analysis for DocCheck

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for DocCheck:

P/E of 19.63 = €8.95 ÷ €0.46 (Based on the trailing twelve months to December 2018.)

Is A High P/E 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 a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.

How Growth Rates Impact P/E Ratios

If earnings fall then in the future the 'E' will be lower. That means even if the current P/E is low, it will increase over time if the share price stays flat. Then, a higher P/E might scare off shareholders, pushing the share price down.

DocCheck shrunk earnings per share by 5.7% last year. But over the longer term (5 years) earnings per share have increased by 16%. And EPS is down 7.6% a year, over the last 3 years. So you wouldn't expect a very high P/E.

How Does DocCheck's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. If you look at the image below, you can see DocCheck has a lower P/E than the average (25.7) in the healthcare services industry classification.

This suggests that market participants think DocCheck will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.

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. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.

So What Does DocCheck's Balance Sheet Tell Us?

DocCheck has net cash of €10m. This is fairly high at 23% 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 DocCheck's P/E Ratio

DocCheck trades on a P/E ratio of 19.6, which is fairly close to the DE market average of 19.7. While the absence of growth in the last year is probably causing a degree of pessimism, the healthy balance sheet means the company retains potential for future growth. So it's not surprising to see it trade on a P/E roughly in line with the market.

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. We don't have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.

You might be able to find a better buy than DocCheck. 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).

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.