This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Software Aktiengesellschaft's (ETR:SOW), to help you decide if the stock is worth further research. Software has a price to earnings ratio of 14.44, based on the last twelve months. In other words, at today's prices, investors are paying €14.44 for every €1 in prior year profit.
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How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Software:
P/E of 14.44 = €32.12 ÷ €2.22 (Based on the year to March 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. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.'
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. Earnings growth means that in the future the 'E' will be higher. 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.
Most would be impressed by Software earnings growth of 15% in the last year. And earnings per share have improved by 7.9% annually, over the last five years. With that performance, you might expect an above average P/E ratio.
Does Software Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. We can see in the image below that the average P/E (37.7) for companies in the software industry is higher than Software's P/E.
Its relatively low P/E ratio indicates that Software shareholders think it will struggle to do as well as other companies in its industry classification. Many investors like to buy stocks when the market is pessimistic about their prospects. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
Remember: P/E Ratios Don't Consider The Balance Sheet
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. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its 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 Software's P/E?
Since Software holds net cash of €183m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Software's P/E Ratio
Software has a P/E of 14.4. That's below the average in the DE market, which is 20.2. The net cash position gives plenty of options to the business, and the recent improvement in EPS is good to see. The below average P/E ratio suggests that market participants don't believe the strong growth will continue.
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 report on the analyst consensus forecasts could help you make a master move on this stock.
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.
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 firstname.lastname@example.org. 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.