The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Simulations Plus, Inc.’s (NASDAQ:SLP) P/E ratio could help you assess the value on offer. Based on the last twelve months, Simulations Plus’s P/E ratio is 78.87. That corresponds to an earnings yield of approximately 1.3%.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Simulations Plus:
P/E of 78.87 = $35.53 ÷ $0.45 (Based on the year to May 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 necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
Does Simulations Plus Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. The image below shows that Simulations Plus has a higher P/E than the average (54.0) P/E for companies in the healthcare services industry.
Simulations Plus’s P/E tells us that market participants think the company will perform better than its industry peers, going forward.
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. When earnings grow, the ‘E’ increases, over time. 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.
Simulations Plus saw earnings per share decrease by 11% last year. But over the longer term (5 years) earnings per share have increased by 19%. Shareholders have some reason to be optimistic, but the future is always uncertain. So investors should delve deeper. I like to check if company insiders have been buying or selling.
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. 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.
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.
Simulations Plus’s Balance Sheet
Since Simulations Plus holds net cash of US$10m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Simulations Plus’s P/E Ratio
With a P/E ratio of 78.9, Simulations Plus is expected to grow earnings very strongly in the years to come. Falling earnings per share is probably keeping traditional value investors away, but the net cash position means the company has time to improve: and the high P/E suggests the market thinks it will.
When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
You might be able to find a better buy than Simulations Plus. 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).
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If you spot an error that warrants correction, please contact the editor at email@example.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.