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 Datacolor AG’s (VTX:DCN) P/E ratio could help you assess the value on offer.
Datacolor has a price to earnings ratio of 29.65, based on the last twelve months.
In other words, at today’s prices, investors are paying CHF29.65 for every CHF1 in prior year profit.
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How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for Datacolor:
P/E of 29.65 = $749.95 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $25.29
(Based on the year to September 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business.
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
P/E ratios primarily reflect market expectations around earnings growth rates.
That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation.
That means even if the current P/E is high, it will reduce over time if the share price stays flat.
A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
Datacolor’s earnings per share fell by 41% in the last twelve months.
But it has grown its earnings per share by 9.1% per year over the last five years.
How Does Datacolor’s P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company.
The image below shows that Datacolor has a higher P/E than the average (18.5) P/E for companies in the electronic industry.
Its relatively high P/E ratio indicates that Datacolor shareholders think it will perform better than other companies in its industry classification.
Shareholders are clearly optimistic, but the future is always uncertain.
So investors should delve deeper. I like to check if company insiders have been buying or selling.
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.
In other words, it does not consider any debt or cash that the company may have on the balance sheet.
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 spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
Datacolor’s Balance Sheet
The extra options and safety that comes with Datacolor’s US$41m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Verdict On Datacolor’s P/E Ratio
Datacolor’s P/E is 29.7 which is above average (18.1) in the CH market.
The recent drop in earnings per share would make some investors cautious,
but the relatively strong balance sheet will allow the company time to invest in growth. Clearly, the high P/E indicates shareholders think it will!
When the market is wrong about a stock, it gives savvy investors an opportunity.
As value investor Benjamin Graham famously said, ‘In the short run, the market is a voting machine but in the long run, it is a weighing machine.’
So this free visual report on analyst forecasts could hold they key to an excellent investment decision.
Of course you might be able to find a better stock than Datacolor. So you may wish to see this free collection of other companies that have grown earnings strongly.
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.
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