Should You Be Tempted To Sell Novisource N.V. (AMS:NOVI) Because Of Its P/E Ratio?

Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how Novisource N.V.'s (AMS:NOVI) P/E ratio could help you assess the value on offer. Based on the last twelve months, Novisource's P/E ratio is 32.97. In other words, at today's prices, investors are paying €32.97 for every €1 in prior year profit.

See our latest analysis for Novisource

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 Novisource:

P/E of 32.97 = EUR1.01 ÷ EUR0.03 (Based on the year to June 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each EUR1 the company has earned over the last year. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.

How Does Novisource'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 Novisource has a higher P/E than the average (19.3) P/E for companies in the commercial services industry.

Its relatively high P/E ratio indicates that Novisource 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 always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. When earnings grow, the 'E' increases, over time. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Novisource saw earnings per share decrease by 73% last year.

Don't Forget: The P/E Does Not Account For Debt or Bank Deposits

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. 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 investing in growth. That means taking on debt (or spending its 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.

So What Does Novisource's Balance Sheet Tell Us?

With net cash of €2.0m, Novisource has a very strong balance sheet, which may be important for its business. Having said that, at 17% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Verdict On Novisource's P/E Ratio

Novisource has a P/E of 33.0. That's higher than the average in its market, which is 20.6. 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!

Investors should be looking to buy stocks that the market is wrong about. 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. Although we don't have analyst forecasts you could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.

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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.