This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Information Services Corporation’s (TSE:ISV) P/E ratio could help you assess the value on offer. Information Services has a P/E ratio of 8.63, based on the last twelve months. In other words, at today’s prices, investors are paying CA$8.63 for every CA$1 in prior year profit.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Information Services:
P/E of 8.63 = CA$16.92 ÷ CA$1.96 (Based on the trailing twelve months to September 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each CA$1 of company earnings. 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.
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. Earnings growth means that in the future the ‘E’ will be higher. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
Information Services increased earnings per share by a whopping 187% last year. And it has improved its earnings per share by 26% per year over the last three years. I’d therefore be a little surprised if its P/E ratio was not relatively high. Unfortunately, earnings per share are down 24% a year, over 5 years.
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. We can see in the image below that the average P/E (13.6) for companies in the real estate industry is higher than Information Services’s P/E.
Its relatively low P/E ratio indicates that Information Services shareholders think it will struggle to do as well as other companies in its industry classification. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or selling.
Remember: P/E Ratios Don’t Consider The Balance Sheet
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. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
Information Services’s Balance Sheet
The extra options and safety that comes with Information Services’s CA$17m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Bottom Line On Information Services’s P/E Ratio
Information Services’s P/E is 8.6 which is below average (14.7) in the CA market. It grew its EPS nicely over the last year, and the healthy balance sheet implies there is more potential for growth. The relatively low P/E ratio implies the market is pessimistic.
Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
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.
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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.