The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We’ll look at IQE plc’s (LON:IQE) P/E ratio and reflect on what it tells us about the company’s share price. IQE has a P/E ratio of 42.82, based on the last twelve months. That means that at current prices, buyers pay £42.82 for every £1 in trailing yearly profits.

See our latest analysis for IQE

How Do You Calculate A P/E Ratio?

The formula for P/E is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for IQE:

P/E of 42.82 = £0.59 ÷ £0.014 (Based on the year to June 2018.)

Is A High P/E Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each £1 the company has earned over the last year. That isn’t a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business’s prospects, relative to stocks with a lower P/E.

How Growth Rates Impact P/E Ratios

When earnings fall, the ‘E’ decreases, over time. That means unless the share price falls, the P/E will increase in a few years. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.

IQE’s earnings per share fell by 43% in the last twelve months. But over the longer term (5 years) earnings per share have increased by 22%. And EPS is down 14% a year, over the last 3 years. This growth rate might warrant a low P/E ratio.

How Does IQE’s P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. As you can see below, IQE has a higher P/E than the average company (15.6) in the semiconductor industry.

IQE’s P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn’t guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

The ‘Price’ in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

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 IQE’s Debt Impact Its P/E Ratio?

Since IQE holds net cash of UK£41m, it can spend on growth, justifying a higher P/E ratio than otherwise.

The Bottom Line On IQE’s P/E Ratio

IQE’s P/E is 42.8 which is above average (15.1) in the GB market. 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.

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 IQE. 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).

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 editorial-team@simplywallst.com.