Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use Altium Limited's (ASX:ALU) P/E ratio to inform your assessment of the investment opportunity. Looking at earnings over the last twelve months, Altium has a P/E ratio of 62.63. That is equivalent to an earnings yield of about 1.6%.
View our latest analysis for Altium
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 Altium:
P/E of 62.63 = $25.41 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $0.41 (Based on the year to June 2019.)
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.
Does Altium 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 Altium has a higher P/E than the average (31.3) P/E for companies in the software industry.
Its relatively high P/E ratio indicates that Altium shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn't guarantee future growth. So further research is always essential. I often monitor director buying and selling.
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. And in that case, the P/E ratio itself will drop rather quickly. Then, a lower P/E should attract more buyers, pushing the share price up.
Altium increased earnings per share by a whopping 41% last year. And earnings per share have improved by 32% annually, over the last five years. So we'd generally expect it to have a relatively high P/E ratio.
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. So it won't reflect the advantage of cash, or disadvantage of debt. 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.
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.