The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Simulations Plus Inc’s (NASDAQ:SLP) P/E ratio could help you assess the value on offer. Based on the last twelve months, Simulations Plus’s P/E ratio is 37.61. That corresponds to an earnings yield of approximately 2.7%.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Simulations Plus:
P/E of 37.61 = $19.39 ÷ $0.52 (Based on the year to August 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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
Earnings growth rates have a big influence on P/E ratios. 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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
It’s nice to see that Simulations Plus grew EPS by a stonking 54% in the last year. And earnings per share have improved by 23% annually, over the last five years. I’d therefore be a little surprised if its P/E ratio was not relatively high.
How Does Simulations Plus’s P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Simulations Plus has a lower P/E than the average (62.5) P/E for companies in the healthcare services industry.
Its relatively low P/E ratio indicates that Simulations Plus shareholders think it will struggle to do as well as other companies in its industry classification. Many investors like to buy stocks when the market is pessimistic about their prospects. You should delve deeper. I like to check if company insiders have been buying or selling.
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. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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.
Simulations Plus’s Balance Sheet
Simulations Plus has net cash of US$9.4m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Bottom Line On Simulations Plus’s P/E Ratio
Simulations Plus’s P/E is 37.6 which is above average (17.9) in the US market. Its net cash position supports a higher P/E ratio, as does its solid recent earnings growth. So it does not seem strange that the P/E is above average.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
But note: Simulations Plus may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio 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.