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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 Solution Dynamics Limited’s (NZSE:SDL) P/E ratio to inform your assessment of the investment opportunity. Solution Dynamics has a price to earnings ratio of 17.49, based on the last twelve months. In other words, at today’s prices, investors are paying NZ$17.49 for every NZ$1 in prior year profit.
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 Solution Dynamics:
P/E of 17.49 = NZ$1.63 ÷ NZ$0.093 (Based on the trailing twelve months to June 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each NZ$1 the company has earned over the last year. 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
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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Solution Dynamics had pretty flat EPS growth in the last year. But over the longer term (5 years) earnings per share have increased by 33%.
How Does Solution Dynamics’s P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Solution Dynamics has a lower P/E than the average (21.7) P/E for companies in the it industry.
Solution Dynamics’s P/E tells us that market participants think it will not fare as well as its peers in the same industry. Since the market seems unimpressed with Solution Dynamics, it’s quite possible it could surprise on the upside. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
The ‘Price’ in P/E reflects the market capitalization of the company. That means it doesn’t take debt or cash into account. 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.
Is Debt Impacting Solution Dynamics’s P/E?
Since Solution Dynamics holds net cash of NZ$2.0m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Solution Dynamics’s P/E Ratio
Solution Dynamics’s P/E is 17.5 which is about average (16.9) in the NZ market. Although the recent drop in earnings per share would keep the market cautious, the relatively strong balance sheet will allow the company to weather a storm; so it isn’t very surprising to see that it has a P/E ratio close to the market average.
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. We don’t have analyst forecasts, but you could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.
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.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.