Why Take-Two Interactive Software, Inc.'s (NASDAQ:TTWO) High P/E Ratio Isn't Necessarily A Bad Thing

This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll show how you can use Take-Two Interactive Software, Inc.'s (NASDAQ:TTWO) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Take-Two Interactive Software's P/E ratio is 54.99. In other words, at today's prices, investors are paying $54.99 for every $1 in prior year profit.

See our latest analysis for Take-Two Interactive Software

How Do I Calculate Take-Two Interactive Software's Price To Earnings Ratio?

The formula for P/E is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Take-Two Interactive Software:

P/E of 54.99 = $103.46 ÷ $1.88 (Based on the year to September 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 is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.

It's nice to see that Take-Two Interactive Software grew EPS by a stonking 52% in the last year. And earnings per share have improved by 114% annually, over the last three years. I'd therefore be a little surprised if its P/E ratio was not relatively high. But earnings per share are down 1.1% per year over the last five years.

How Does Take-Two Interactive Software'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 Take-Two Interactive Software has a higher P/E than the average (20.9) P/E for companies in the entertainment industry.

Its relatively high P/E ratio indicates that Take-Two Interactive Software shareholders think it will perform better than other companies in its industry classification. Shareholders are clearly optimistic, but the future is always uncertain. 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

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn't take debt or cash into account. 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.

Is Debt Impacting Take-Two Interactive Software's P/E?

Take-Two Interactive Software has net cash of US$1.0b. 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 Take-Two Interactive Software's P/E Ratio

Take-Two Interactive Software has a P/E of 55. That's significantly higher than the average in the US market, which is 16.8. Its net cash position supports a higher P/E ratio, as does its solid recent earnings growth. Therefore it seems reasonable that the market would have relatively high expectations of the company

Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this freevisual report on analyst forecasts could hold they key to an excellent investment decision.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this freelist 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 editorial-team@simplywallst.com.

Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.