Despite Its High P/E Ratio, Is discoverIE Group plc (LON:DSCV) Still Undervalued?

Today, we’ll introduce the concept of the P/E ratio for those who are learning about investing. We’ll look at discoverIE Group plc’s (LON:DSCV) P/E ratio and reflect on what it tells us about the company’s share price. discoverIE Group has a price to earnings ratio of 23.44, based on the last twelve months. That is equivalent to an earnings yield of about 4.3%.

See our latest analysis for discoverIE Group

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 discoverIE Group:

P/E of 23.44 = £4.69 ÷ £0.20 (Based on the year to March 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn’t necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.

Does discoverIE Group Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio indicates whether the market has higher or lower expectations of a company. As you can see below, discoverIE Group has a higher P/E than the average company (19.6) in the electronic industry.

LSE:DSCV Price Estimation Relative to Market, October 20th 2019
LSE:DSCV Price Estimation Relative to Market, October 20th 2019

Its relatively high P/E ratio indicates that discoverIE Group shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn’t guarantee future growth. So investors should delve deeper. I like to check if company insiders have been buying or selling.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

Notably, discoverIE Group grew EPS by a whopping 34% in the last year. And earnings per share have improved by 18% annually, over the last five years. So we’d generally expect it to have a relatively high P/E ratio.

Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits

Don’t forget that the P/E ratio considers market capitalization. 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.

Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).

How Does discoverIE Group’s Debt Impact Its P/E Ratio?

discoverIE Group’s net debt is 15% of its market cap. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.

The Verdict On discoverIE Group’s P/E Ratio

discoverIE Group has a P/E of 23.4. That’s higher than the average in its market, which is 16.7. While the company does use modest debt, its recent earnings growth is superb. So on this analysis a high P/E ratio seems reasonable.

Investors should be looking to buy stocks that the market is wrong about. 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 be able to find a better stock than discoverIE Group. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.