Don't Sell SAP SE (FRA:SAP) Before You Read This

Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll apply a basic P/E ratio analysis to SAP SE's (FRA:SAP), to help you decide if the stock is worth further research. SAP has a P/E ratio of 42.73, based on the last twelve months. In other words, at today's prices, investors are paying €42.73 for every €1 in prior year profit.

See our latest analysis for SAP

How Do You Calculate SAP's P/E Ratio?

The formula for P/E is:

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

Or for SAP:

P/E of 42.73 = €111.36 ÷ €2.61 (Based on the trailing twelve months to June 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. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.

Does SAP 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, SAP has a higher P/E than the average company (35.3) in the software industry.

That means that the market expects SAP will outperform other companies in its industry.

How Growth Rates Impact P/E Ratios

When earnings fall, the 'E' decreases, over time. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.

SAP shrunk earnings per share by 27% over the last year. And over the longer term (3 years) earnings per share have decreased 4.3% annually. This might lead to low expectations.

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

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won't reflect the advantage of cash, or disadvantage of debt. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.

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.

So What Does SAP's Balance Sheet Tell Us?

The extra options and safety that comes with SAP's €4.1b net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.

The Verdict On SAP's P/E Ratio

SAP has a P/E of 42.7. That's higher than the average in its market, which is 18.8. The recent drop in earnings per share would make some investors cautious, but the healthy balance sheet means the company retains potential for future growth. If fails to eventuate, the current high P/E could prove to be temporary, as the share price falls.

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.

Of course you might be able to find a better stock than SAP. 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.