The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We’ll look at Information Services Corporation’s (TSE:ISV) P/E ratio and reflect on what it tells us about the company’s share price. Based on the last twelve months, Information Services’s P/E ratio is 16.73. That is equivalent to an earnings yield of about 6.0%.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Information Services:
P/E of 16.73 = CAD14.57 ÷ CAD0.87 (Based on the trailing twelve months to September 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each CAD1 of company earnings. 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.
How Does Information Services’s P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. As you can see below, Information Services has a higher P/E than the average company (12.5) in the real estate industry.
Its relatively high P/E ratio indicates that Information Services 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 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
Companies that shrink earnings per share quickly will rapidly decrease the ‘E’ in the equation. That means unless the share price falls, the P/E will increase in a few years. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
Information Services’s earnings per share fell by 55% in the last twelve months. And it has shrunk its earnings per share by 4.4% per year over the last five years. This could justify a pessimistic P/E.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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 expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
So What Does Information Services’s Balance Sheet Tell Us?
Since Information Services holds net cash of CA$1.3m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Information Services’s P/E Ratio
Information Services has a P/E of 16.7. That’s around the same as the average in the CA market, which is 15.9. Although the recent drop in earnings per share would keep the market cautious, the net cash position means it’s not surprising that expectations put the company roughly in line with the market average P/E.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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 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 firstname.lastname@example.org. 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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