This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we'll show how BP p.l.c.'s (LON:BP.) P/E ratio could help you assess the value on offer. Based on the last twelve months, BP's P/E ratio is 14. That corresponds to an earnings yield of approximately 7.1%.
How Do You Calculate BP's P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for BP:
P/E of 14 = $6.17 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $0.44 (Based on the trailing twelve months to June 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each £1 of company earnings. That isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
Does BP 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. You can see in the image below that the average P/E (7.6) for companies in the oil and gas industry is lower than BP's P/E.
BP's P/E tells us that market participants think the company will perform better than its industry peers, going forward. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. And in that case, the P/E ratio itself will drop rather quickly. Then, a lower P/E should attract more buyers, pushing the share price up.
BP increased earnings per share by an impressive 24% over the last twelve months. In contrast, EPS has decreased by 6.4%, annually, over 5 years.
Remember: P/E Ratios Don't Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. That means it doesn't take debt or cash into account. 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).
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
Is Debt Impacting BP's P/E?
BP's net debt equates to 48% of its market capitalization. While it's worth keeping this in mind, it isn't a worry.
The Bottom Line On BP's P/E Ratio
BP's P/E is 14 which is below average (16.2) in the GB market. The company does have a little debt, and EPS growth was good last year. If it continues to grow, then the current low P/E may prove to be unjustified. Given analysts are expecting further growth, one might have expected a higher P/E ratio. That may be worth further research.
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.
You might be able to find a better buy than BP. 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).
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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.