This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We’ll show how you can use Diageo plc’s (LON:DGE) P/E ratio to inform your assessment of the investment opportunity. Diageo has a P/E ratio of 22.42, based on the last twelve months. In other words, at today’s prices, investors are paying £22.42 for every £1 in prior year profit.
How Do You Calculate Diageo’s P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Diageo:
P/E of 22.42 = £27.27 ÷ £1.22 (Based on the year to June 2018.)
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. 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.’
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. When earnings grow, the ‘E’ increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
Diageo increased earnings per share by an impressive 12% over the last twelve months. And its annual EPS growth rate over 5 years is 5.3%. So one might expect an above average P/E ratio.
How Does Diageo’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Diageo has a P/E ratio that is roughly in line with the beverage industry average (23.9).
Its P/E ratio suggests that Diageo shareholders think that in the future it will perform about the same as other companies in its industry classification. If the company has better than average prospects, then the market might be underestimating it. Further research into factors such asmanagement tenure, could help you form your own view on whether that is likely.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
The ‘Price’ in P/E reflects the market capitalization of the company. That means it doesn’t take debt or cash into account. 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.
Diageo’s Balance Sheet
Net debt totals 14% of Diageo’s market cap. That’s enough debt to impact the P/E ratio a little; so keep it in mind if you’re comparing it to companies without debt.
The Bottom Line On Diageo’s P/E Ratio
Diageo has a P/E of 22.4. That’s higher than the average in the GB market, which is 16.1. While the company does use modest debt, its recent earnings growth is impressive. Therefore it seems reasonable that the market would have relatively high expectations of the company
Investors have an opportunity when market expectations about a stock are wrong. People often underestimate remarkable growth — so investors can make money when fast growth is not fully appreciated. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
But note: Diageo may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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 firstname.lastname@example.org.