Does Adobe Inc.'s (NASDAQ:ADBE) P/E Ratio Signal A Buying Opportunity?

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This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll show how you can use Adobe Inc.'s (NASDAQ:ADBE) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Adobe's P/E ratio is 50.44. In other words, at today's prices, investors are paying $50.44 for every $1 in prior year profit.

Check out our latest analysis for Adobe

How Do I Calculate Adobe's Price To Earnings Ratio?

The formula for P/E is:

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

Or for Adobe:

P/E of 50.44 = $276.3 ÷ $5.48 (Based on the year to March 2019.)

Is A High P/E 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.

Adobe increased earnings per share by a whopping 44% last year. And it has bolstered its earnings per share by 59% per year over the last five years. So we'd generally expect it to have a relatively high P/E ratio.

Does Adobe Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio indicates whether the market has higher or lower expectations of a company. You can see in the image below that the average P/E (51.3) for companies in the software industry is roughly the same as Adobe's P/E.

Adobe's P/E tells us that market participants think its prospects are roughly in line with its industry. If the company has better than average prospects, then the market might be underestimating it. I inform my view byby checking management tenure and remuneration, among other things.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. 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.

Adobe's Balance Sheet

Adobe's net debt is 0.7% of its market cap. So it doesn't have as many options as it would with net cash, but its debt would not have much of an impact on its P/E ratio.

The Bottom Line On Adobe's P/E Ratio

Adobe has a P/E of 50.4. That's higher than the average in the US market, which is 17.7. The company is not overly constrained by its modest debt levels, and its recent EPS growth is nothing short of stand-out. So to be frank we are not surprised it has a high P/E ratio.

Investors have an opportunity when market expectations about a stock are wrong. 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: Adobe 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).

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 editorial-team@simplywallst.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.