The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at Abcam plc's (LON:ABC) P/E ratio and reflect on what it tells us about the company's share price. Abcam has a price to earnings ratio of 52.09, based on the last twelve months. That is equivalent to an earnings yield of about 1.9%.
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 Abcam:
P/E of 52.09 = £11.44 ÷ £0.22 (Based on the trailing twelve months to June 2019.)
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.
Does Abcam Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. As you can see below, Abcam has a higher P/E than the average company (31.9) in the biotechs industry.
That means that the market expects Abcam will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So further research is always essential. I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. Earnings growth means that in the future the 'E' will be higher. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Abcam shrunk earnings per share by 28% over the last year. But EPS is up 5.1% over the last 5 years.
Remember: P/E Ratios Don't Consider The Balance Sheet
Don't forget that the P/E ratio considers market capitalization. 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 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.
How Does Abcam's Debt Impact Its P/E Ratio?
Since Abcam holds net cash of UK£87m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Abcam's P/E Ratio
Abcam's P/E is 52.1 which suggests the market is more focussed on the future opportunity rather than the current level of earnings. The recent drop in earnings per share might keep value investors away, but the healthy balance sheet means the company retains potential for future growth. If fails to eventuate, the current high P/E could prove to be temporary, as the share price falls.
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 the key to an excellent investment decision.
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.
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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.