This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Teradyne, Inc.’s (NASDAQ:TER) P/E ratio could help you assess the value on offer. Teradyne has a price to earnings ratio of 16.44, based on the last twelve months. That means that at current prices, buyers pay $16.44 for every $1 in trailing yearly profits.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Teradyne:
P/E of 16.44 = $39.58 ÷ $2.41 (Based on the trailing twelve months to December 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. When earnings grow, the ‘E’ increases, over time. 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.
Notably, Teradyne grew EPS by a whopping 85% in the last year. And earnings per share have improved by 17% annually, over the last five years. With that performance, I would expect it to have an above average P/E ratio.
How Does Teradyne’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. We can see in the image below that the average P/E (18.5) for companies in the semiconductor industry is higher than Teradyne’s P/E.
This suggests that market participants think Teradyne will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
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 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.
Teradyne’s Balance Sheet
The extra options and safety that comes with Teradyne’s US$737m 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 Teradyne’s P/E Ratio
Teradyne has a P/E of 16.4. That’s around the same as the average in the US market, which is 17.5. With a strong balance sheet combined with recent growth, the P/E implies the market is quite pessimistic.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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 report on the analyst consensus forecasts could help you make a master move on this stock.
You might be able to find a better buy than Teradyne. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
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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.