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 Activision Blizzard Inc’s (NASDAQ:ATVI) P/E ratio could help you assess the value on offer. Based on the last twelve months, Activision Blizzard’s P/E ratio is 65.7. In other words, at today’s prices, investors are paying $65.7 for every $1 in prior year profit.
How Do You Calculate Activision Blizzard’s P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Activision Blizzard:
P/E of 65.7 = $49.88 ÷ $0.76 (Based on the trailing twelve months to September 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 $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
Companies that shrink earnings per share quickly will rapidly decrease the ‘E’ in the equation. That means even if the current P/E is low, it will increase over time if the share price stays flat. Then, a higher P/E might scare off shareholders, pushing the share price down.
Activision Blizzard’s earnings per share fell by 49% in the last twelve months. And EPS is down 3.6% a year, over the last 5 years. This might lead to muted expectations.
How Does Activision Blizzard’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 Activision Blizzard has a significantly higher P/E than the average (21) P/E for companies in the entertainment industry.
Activision Blizzard’s P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn’t guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
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 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.
Activision Blizzard’s Balance Sheet
The extra options and safety that comes with Activision Blizzard’s US$754m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Verdict On Activision Blizzard’s P/E Ratio
Activision Blizzard’s P/E is 65.7 which is way above average (18) in the US market. The recent drop in earnings per share would make some investors cautious, but the net cash position means the company has time to improve: and the high P/E suggests the market thinks it will.
Investors have an opportunity when market expectations about a stock are wrong. As value investor Benjamin Graham famously said, ‘In the short run, the market is a voting machine but in the long run, it is a weighing machine.’ So this free visual report on analyst forecasts could hold they key to an excellent investment decision.
But note: Activision Blizzard 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.