Despite Its High P/E Ratio, Is rhipe Limited (ASX:RHP) Still Undervalued?

This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll show how you can use rhipe Limited's (ASX:RHP) P/E ratio to inform your assessment of the investment opportunity. rhipe has a P/E ratio of 63.8, based on the last twelve months. In other words, at today's prices, investors are paying A$63.8 for every A$1 in prior year profit.

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See our latest analysis for rhipe

How Do I Calculate A Price To Earnings Ratio?

The formula for P/E is:

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

Or for rhipe:

P/E of 63.8 = A$2.36 ÷ A$0.037 (Based on the trailing twelve months to December 2018.)

Is A High P/E Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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 Growth Rates Impact P/E Ratios

Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. Earnings growth means that in the future the 'E' will be higher. That means even if the current P/E is high, it will reduce over time if the share price stays flat. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

rhipe increased earnings per share by a whopping 42% last year. And earnings per share have improved by 49% annually, over the last five years. I'd therefore be a little surprised if its P/E ratio was not relatively high.

Does rhipe 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. You can see in the image below that the average P/E (15.4) for companies in the it industry is a lot lower than rhipe's P/E.

Its relatively high P/E ratio indicates that rhipe shareholders think it will perform better than other companies in its industry classification. Shareholders are clearly optimistic, but the future is always uncertain. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. Thus, the metric does not reflect cash or debt held by the company. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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.

How Does rhipe's Debt Impact Its P/E Ratio?

rhipe has net cash of AU$23m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.

The Bottom Line On rhipe's P/E Ratio

rhipe's P/E is 63.8 which suggests the market is more focussed on the future opportunity rather than the current level of earnings. Its net cash position is the cherry on top of its superb EPS growth. So based on this analysis we'd expect rhipe to have a high P/E ratio.

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.

You might be able to find a better buy than rhipe. 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).

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.