The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We’ll show how you can use Digi International Inc.’s (NASDAQ:DGII) P/E ratio to inform your assessment of the investment opportunity. Digi International has a P/E ratio of 34.92, based on the last twelve months. That means that at current prices, buyers pay $34.92 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 = Price per Share ÷ Earnings per Share (EPS)
Or for Digi International:
P/E of 34.92 = $13.47 ÷ $0.39 (Based on the trailing twelve months to June 2019.)
Is A High Price-to-Earnings 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.
Does Digi International Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. The image below shows that Digi International has a higher P/E than the average (30.5) P/E for companies in the communications industry.
Digi International’s P/E tells us that market participants think the company will perform better than its industry peers, going forward.
How Growth Rates Impact P/E Ratios
Companies that shrink earnings per share quickly will rapidly decrease the ‘E’ in the equation. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. A higher P/E should indicate the stock is expensive relative to others — and that may encourage shareholders to sell.
In the last year, Digi International grew EPS like Taylor Swift grew her fan base back in 2010; the 294% gain was both fast and well deserved. The sweetener is that the annual five year growth rate of 24% is also impressive. So I’d be surprised if the P/E ratio was not above average. Unfortunately, earnings per share are down 9.6% a year, over 3 years.
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. So it won’t reflect the advantage of cash, or disadvantage of debt. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
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).
So What Does Digi International’s Balance Sheet Tell Us?
With net cash of US$86m, Digi International has a very strong balance sheet, which may be important for its business. Having said that, at 23% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On Digi International’s P/E Ratio
Digi International’s P/E is 34.9 which is above average (17.4) in its market. The excess cash it carries is the gravy on top its fast EPS growth. So based on this analysis we’d expect Digi International to have 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.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E 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 email@example.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.