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Today, we’ll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we’ll show how Alliance Data Systems Corporation’s (NYSE:ADS) P/E ratio could help you assess the value on offer. Alliance Data Systems has a P/E ratio of 8.3, based on the last twelve months. That means that at current prices, buyers pay $8.3 for every $1 in trailing yearly profits.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Alliance Data Systems:
P/E of 8.3 = $146.81 ÷ $17.7 (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. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Alliance Data Systems increased earnings per share by an impressive 20% over the last twelve months. And it has bolstered its earnings per share by 12% per year over the last five years. With that performance, you might expect an above average P/E ratio.
Does Alliance Data Systems Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Alliance Data Systems has a lower P/E than the average (36.4) P/E for companies in the it industry.
Alliance Data Systems’s P/E tells us that market participants think it will not fare as well as its peers in the same industry.
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. So it won’t reflect the advantage of cash, or disadvantage of debt. 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.
How Does Alliance Data Systems’s Debt Impact Its P/E Ratio?
Alliance Data Systems’s net debt is considerable, at 263% of its market cap. If you want to compare its P/E ratio to other companies, you must keep in mind that these debt levels would usually warrant a relatively low P/E.
The Bottom Line On Alliance Data Systems’s P/E Ratio
Alliance Data Systems’s P/E is 8.3 which is below average (18.2) in the US market. The company may have significant debt, but EPS growth was good last year. If it continues to grow, then the current low P/E may prove to be unjustified.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
Of course you might be able to find a better stock than Alliance Data Systems. So you may wish to see this free collection of other companies that have grown earnings strongly.
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 firstname.lastname@example.org. 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.