The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We’ll look at Microsoft Corporation’s (NASDAQ:MSFT) P/E ratio and reflect on what it tells us about the company’s share price. Microsoft has a P/E ratio of 44.26, based on the last twelve months. In other words, at today’s prices, investors are paying $44.26 for every $1 in prior year profit.
How Do You Calculate Microsoft’s P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Microsoft:
P/E of 44.26 = $108.29 ÷ $2.45 (Based on the year to September 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. 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. When earnings grow, the ‘E’ increases, over time. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Microsoft shrunk earnings per share by 28% over the last year. But EPS is up 8.9% over the last 3 years. And EPS is down 2.8% a year, over the last 5 years. This might lead to muted expectations.
How Does Microsoft’s P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. As you can see below Microsoft has a P/E ratio that is fairly close for the average for the software industry, which is 44.7.
That indicates that the market expects Microsoft will perform roughly in line with other companies in its industry. The company could surprise by performing better than average, in the future. Checking factors such as the tenure of the board and management could help you form your own view on if that will happen.
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. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining cash).
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.
Is Debt Impacting Microsoft’s P/E?
Since Microsoft holds net cash of US$53b, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Microsoft’s P/E Ratio
Microsoft’s P/E is 44.3 which is above average (17.9) in the US market. Falling earnings per share is probably keeping traditional value investors away, but the healthy balance sheet means the company retains potential for future growth. If fails to eventuate, the current high P/E could prove to be temporary, as the share price falls.
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 free report on the analyst consensus forecasts could help you make a master move on this stock.
But note: Microsoft 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 email@example.com.