Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how MIPS AB (publ)'s (STO:MIPS) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, MIPS has a P/E ratio of 55.06. In other words, at today's prices, investors are paying SEK55.06 for every SEK1 in prior year profit.

View our latest analysis for MIPS

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

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

Or for MIPS:

P/E of 55.06 = SEK166.2 ÷ SEK3.02 (Based on the year to June 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that investors are paying a higher price for each SEK1 of company 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 MIPS's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. As you can see below, MIPS has a higher P/E than the average company (22.4) in the leisure industry.

Its relatively high P/E ratio indicates that MIPS shareholders think it will perform better than other companies in its industry classification. Shareholders are clearly optimistic, but the future is always uncertain. 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

Probably the most important factor in determining what P/E a company trades on is the earnings growth. 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. Then, a lower P/E should attract more buyers, pushing the share price up.

MIPS's earnings made like a rocket, taking off 155% last year. Even better, EPS is up 45% per year over three years. So we'd absolutely expect it to have a relatively high P/E ratio.

Remember: P/E Ratios Don't Consider The Balance Sheet

The 'Price' in P/E reflects the market capitalization of the company. So it won't reflect the advantage of cash, or disadvantage of debt. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

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 MIPS's P/E?

Since MIPS holds net cash of kr167m, it can spend on growth, justifying a higher P/E ratio than otherwise.

The Bottom Line On MIPS's P/E Ratio

With a P/E ratio of 55.1, MIPS is expected to grow earnings very strongly in the years to come. Its net cash position is the cherry on top of its superb EPS growth. So based on this analysis we'd expect MIPS to have a high P/E ratio.

Investors have an opportunity when market expectations about a stock are wrong. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. 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.

You might be able to find a better buy than MIPS. 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.