This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Fair Isaac Corporation’s (NYSE:FICO) P/E ratio could help you assess the value on offer. Based on the last twelve months, Fair Isaac’s P/E ratio is 54.93. That means that at current prices, buyers pay $54.93 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 = Price per Share ÷ Earnings per Share (EPS)
Or for Fair Isaac:
P/E of 54.93 = $279.11 ÷ $5.08 (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
Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the ‘E’ will be higher. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.
Notably, Fair Isaac grew EPS by a whopping 26% in the last year. And earnings per share have improved by 16% annually, over the last five years. I’d therefore be a little surprised if its P/E ratio was not relatively high.
How Does Fair Isaac’s P/E Ratio Compare To Its Peers?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. You can see in the image below that the average P/E (56) for companies in the software industry is roughly the same as Fair Isaac’s P/E.
That indicates that the market expects Fair Isaac will perform roughly in line with other companies in its industry. The company could surprise by performing better than average, in the future. 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
It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. In other words, it does not consider any debt or cash that the company may have on the balance sheet. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
Fair Isaac’s Balance Sheet
Net debt totals just 9.3% of Fair Isaac’s 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 Fair Isaac’s P/E Ratio
Fair Isaac’s P/E is 54.9 which suggests the market is more focussed on the future opportunity rather than the current level of earnings. Its debt levels do not imperil its balance sheet and it is growing EPS strongly. So on this analysis it seems reasonable that its P/E ratio is above average.
Investors have an opportunity when market expectations about a stock are wrong. 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.
You might be able to find a better buy than Fair Isaac. 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 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.