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 Enghouse Systems Limited’s (TSE:ENGH) P/E ratio to inform your assessment of the investment opportunity. Enghouse Systems has a price to earnings ratio of 41.72, based on the last twelve months. In other words, at today’s prices, investors are paying CA$41.72 for every CA$1 in prior year profit.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Enghouse Systems:
P/E of 41.72 = CAD54.08 ÷ CAD1.30 (Based on the year to October 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’.
How Does Enghouse Systems’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (25.0) for companies in the software industry is lower than Enghouse Systems’s P/E.
That means that the market expects Enghouse Systems will outperform other companies in its industry. Clearly the market expects growth, but it isn’t guaranteed. 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. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.
Most would be impressed by Enghouse Systems earnings growth of 22% in the last year. And it has bolstered its earnings per share by 18% per year over the last five years. This could arguably justify 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. That means it doesn’t take debt or cash into account. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
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 Enghouse Systems’s Debt Impact Its P/E Ratio?
Enghouse Systems has net cash of CA$149m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Verdict On Enghouse Systems’s P/E Ratio
Enghouse Systems’s P/E is 41.7 which is above average (16.0) in its market. Its strong balance sheet gives the company plenty of resources for extra growth, and it has already proven it can grow. So it does not seem strange that the P/E is above average.
Investors should be looking to buy stocks that the market is wrong about. 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.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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.
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