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This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll look at Solution Dynamics Limited’s (NZSE:SDL) P/E ratio and reflect on what it tells us about the company’s share price. Looking at earnings over the last twelve months, Solution Dynamics has a P/E ratio of 35.08. That is equivalent to an earnings yield of about 2.9%.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Solution Dynamics:
P/E of 35.08 = NZ$1.68 ÷ NZ$0.048 (Based on the year to December 2018.)
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. 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
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. A higher P/E should indicate the stock is expensive relative to others — and that may encourage shareholders to sell.
Solution Dynamics shrunk earnings per share by 53% over the last year. But over the longer term (5 years) earnings per share have increased by 24%. And over the longer term (3 years) earnings per share have decreased 7.4% annually. This might lead to low expectations.
How Does Solution Dynamics’s P/E Ratio Compare To Its Peers?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. You can see in the image below that the average P/E (16.8) for companies in the it industry is lower than Solution Dynamics’s P/E.
Its relatively high P/E ratio indicates that Solution Dynamics shareholders think it will perform better than other companies in its industry classification. 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.
Remember: P/E Ratios Don’t Consider The Balance Sheet
The ‘Price’ in P/E reflects the market capitalization of the company. So it won’t reflect the advantage of cash, or disadvantage of debt. 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.
Is Debt Impacting Solution Dynamics’s P/E?
Solution Dynamics has net cash of NZ$1.4m. 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 Solution Dynamics’s P/E Ratio
Solution Dynamics trades on a P/E ratio of 35.1, which is above the NZ market average of 17.8. Falling earnings per share is probably keeping traditional value investors away, but the healthy balance sheet means the company retains potential for future growth. If fails to eventuate, the current high P/E could prove to be temporary, as the share price falls.
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. Although we don’t have analyst forecasts, shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
Of course you might be able to find a better stock than Solution Dynamics. So you may wish to see this free collection of other companies that have grown earnings strongly.
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 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.