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 Diodes Incorporated's (NASDAQ:DIOD) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, Diodes has a P/E ratio of 15.57. In other words, at today's prices, investors are paying $15.57 for every $1 in prior year profit.

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. 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.'

The P/E ratio indicates whether the market has higher or lower expectations of a company. We can see in the image below that the average P/E (28.6) for companies in the semiconductor industry is higher than Diodes's P/E.



This suggests that market participants think Diodes will underperform other companies in its industry. Many investors like to buy stocks when the market is pessimistic about their prospects. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. When earnings grow, the 'E' increases, over time. 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.

Diodes's earnings made like a rocket, taking off 360% last year. The sweetener is that the annual five year growth rate of 20% is also impressive. With that kind of growth rate we would generally expect a high P/E ratio.

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.

Diodes has net cash of US$55m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.

Diodes trades on a P/E ratio of 15.6, which is below the US market average of 18. The net cash position gives plenty of options to the business, and the recent improvement in EPS is good to see. The relatively low P/E ratio implies the market is pessimistic.

Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free report on the analyst consensus forecasts could help you make a master move on this stock.

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.

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.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. Thank you for reading.

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