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Despite Its High P/E Ratio, Is Admiral Group plc (LON:ADM) Still Undervalued?

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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 Admiral Group plc's (LON:ADM) P/E ratio could help you assess the value on offer. Based on the last twelve months, Admiral Group's P/E ratio is 15.6. In other words, at today's prices, investors are paying £15.6 for every £1 in prior year profit.

See our latest analysis for Admiral Group

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 Admiral Group:

P/E of 15.6 = £21.39 ÷ £1.37 (Based on the trailing twelve months to December 2018.)

Is A High Price-to-Earnings 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

Earnings growth rates have a big influence on P/E ratios. When earnings grow, the 'E' increases, over time. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.

Most would be impressed by Admiral Group earnings growth of 17% in the last year. And earnings per share have improved by 2.7% annually, over the last five years. This could arguably justify a relatively high P/E ratio.

How Does Admiral Group's P/E Ratio Compare To Its Peers?

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 (14.4) for companies in the insurance industry is lower than Admiral Group's P/E.

LSE:ADM Price Estimation Relative to Market, March 27th 2019
LSE:ADM Price Estimation Relative to Market, March 27th 2019

Its relatively high P/E ratio indicates that Admiral Group shareholders think it will perform better than other companies in its industry classification. Shareholders are clearly optimistic, but the future is always uncertain. So further research is always essential. I often monitor director buying and selling.

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. 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 expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

Admiral Group's Balance Sheet

Since Admiral Group holds net cash of UK£2.8b, it can spend on growth, justifying a higher P/E ratio than otherwise.

The Bottom Line On Admiral Group's P/E Ratio

Admiral Group trades on a P/E ratio of 15.6, which is fairly close to the GB market average of 15.8. The balance sheet is healthy, and recent EPS growth impressive, but the P/E implies some caution from the market.

Investors have an opportunity when market expectations about a stock are wrong. 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.

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.