Why SWK Holdings Corporation's (NASDAQ:SWKH) High P/E Ratio Isn't Necessarily A Bad Thing

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at SWK Holdings Corporation's (NASDAQ:SWKH) P/E ratio and reflect on what it tells us about the company's share price. What is SWK Holdings's P/E ratio? Well, based on the last twelve months it is 6.74. That is equivalent to an earnings yield of about 14.8%.

View our latest analysis for SWK Holdings

How Do I Calculate A Price To Earnings Ratio?

The formula for P/E is:

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

Or for SWK Holdings:

P/E of 6.74 = $12.450 ÷ $1.846 (Based on the trailing twelve months to December 2019.)

(Note: the above calculation results may not be precise due to rounding.)

Is A High P/E Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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 Does SWK Holdings'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. The image below shows that SWK Holdings has a higher P/E than the average (4.5) P/E for companies in the diversified financial industry.

SWK Holdings'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 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

When earnings fall, the 'E' decreases, over time. That means unless the share price falls, the P/E will increase in a few years. Then, a higher P/E might scare off shareholders, pushing the share price down.

SWK Holdings's earnings made like a rocket, taking off 289% last year. Unfortunately, earnings per share are down 10% a year, over 5 years.

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. Thus, the metric does not reflect cash or debt held by the company. 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 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.

Is Debt Impacting SWK Holdings's P/E?

Since SWK Holdings holds net cash of US$15m, it can spend on growth, justifying a higher P/E ratio than otherwise.

The Verdict On SWK Holdings's P/E Ratio

SWK Holdings trades on a P/E ratio of 6.7, which is below the US market average of 13.3. It grew its EPS nicely over the last year, and the healthy balance sheet implies there is more potential for growth. The relatively low P/E ratio implies the market is pessimistic.

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. Although we don't have analyst forecasts shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.

Of course you might be able to find a better stock than SWK Holdings. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.

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. Thank you for reading.