The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Endava plc’s (NYSE:DAVA) P/E ratio could help you assess the value on offer. Endava has a price to earnings ratio of 52.97, based on the last twelve months. That is equivalent to an earnings yield of about 1.9%.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for Endava:
P/E of 52.97 = £20.95 (Note: this is the share price in the reporting currency, namely, GBP ) ÷ £0.40 (Based on the year to December 2018.)
Is A High Price-to-Earnings Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. Earnings growth means that in the future the ‘E’ will be higher. 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.
Endava maintained roughly steady earnings over the last twelve months. But over the longer term (5 years) earnings per share have increased by 16%.
Does Endava Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. As you can see below, Endava has a higher P/E than the average company (31.1) in the it industry.
Endava’s P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn’t guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
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. 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.
While growth expenditure doesn’t always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
How Does Endava’s Debt Impact Its P/E Ratio?
Since Endava holds net cash of UK£51m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Endava’s P/E Ratio
Endava has a P/E of 53. That’s higher than the average in the US market, which is 18.1. Earnings improved over the last year. And the net cash position provides the company with multiple options. The high P/E suggests the market thinks further growth will come.
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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
But note: Endava 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 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.