The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We’ll show how you can use Electronic Arts Inc.’s (NASDAQ:EA) P/E ratio to inform your assessment of the investment opportunity. Electronic Arts has a P/E ratio of 11.28, based on the last twelve months. That means that at current prices, buyers pay $11.28 for every $1 in trailing yearly profits.
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How Do You Calculate Electronic Arts’s P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Electronic Arts:
P/E of 11.28 = USD108.01 ÷ USD9.58 (Based on the trailing twelve months to December 2019.)
Is A High Price-to-Earnings Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. 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’.
Does Electronic Arts Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Electronic Arts has a lower P/E than the average (23.8) P/E for companies in the entertainment industry.
Electronic Arts’s P/E tells us that market participants think it will not fare as well as its peers in the same industry. Since the market seems unimpressed with Electronic Arts, it’s quite possible it could surprise on the upside. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company’s P/E multiple. If earnings are growing quickly, then the ‘E’ in the equation will increase faster than it would otherwise. And in that case, the P/E ratio itself will drop rather quickly. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
In the last year, Electronic Arts grew EPS like Taylor Swift grew her fan base back in 2010; the 106% gain was both fast and well deserved. The sweetener is that the annual five year growth rate of 29% is also impressive. With that kind of growth rate we would generally expect a 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. That means it doesn’t take debt or cash into account. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
While growth expenditure doesn’t always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
So What Does Electronic Arts’s Balance Sheet Tell Us?
Electronic Arts has net cash of US$4.6b. This is fairly high at 15% 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 Electronic Arts’s P/E Ratio
Electronic Arts has a P/E of 11.3. That’s below the average in the US market, which is 18.2. Not only should the net cash position reduce risk, but the recent growth has been impressive. One might conclude that the market is a bit pessimistic, given the low P/E ratio.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
But note: Electronic Arts may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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.
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