Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at SDL plc's (LON:SDL) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, SDL has a P/E ratio of 31.41. In other words, at today's prices, investors are paying £31.41 for every £1 in prior year profit.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for SDL:
P/E of 31.41 = £5.98 ÷ £0.19 (Based on the year to June 2019.)
Is A High P/E 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 Does SDL's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. As you can see below SDL has a P/E ratio that is fairly close for the average for the software industry, which is 32.2.
SDL's P/E tells us that market participants think its prospects are roughly in line with its industry. So if SDL actually outperforms its peers going forward, that should be a positive for the share price. Further research into factors such as insider buying and selling, could help you form your own view on whether that is likely.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means unless the share price increases, the P/E will reduce in a few years. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
SDL's earnings per share fell by 7.9% in the last twelve months.
Remember: P/E Ratios Don't Consider The Balance Sheet
The 'Price' in P/E reflects the market capitalization of the company. 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.
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
So What Does SDL's Balance Sheet Tell Us?
The extra options and safety that comes with SDL's UK£1.1m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Bottom Line On SDL's P/E Ratio
SDL has a P/E of 31.4. That's higher than the average in its market, which is 18.3. Falling earnings per share is probably keeping traditional value investors away, 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!
Investors should be looking to buy stocks that the market is wrong about. 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.
You might be able to find a better buy than SDL. 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).
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.
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