Want to participate in a research study? Help shape the future of investing tools and earn a $60 gift card!
The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll show how you can use Ansell Limited's (ASX:ANN) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Ansell's P/E ratio is 22.4. That is equivalent to an earnings yield of about 4.5%.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for Ansell:
P/E of 22.4 = $17.84 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $0.80 (Based on the year to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each A$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
When earnings fall, the 'E' decreases, over time. That means unless the share price falls, the P/E will increase in a few years. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
Ansell's earnings per share fell by 12% in the last twelve months. But it has grown its earnings per share by 4.6% per year over the last five years. And it has shrunk its earnings per share by 5.6% per year over the last three years. This growth rate might warrant a low P/E ratio. This growth rate might warrant a low P/E ratio.
How Does Ansell's P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. If you look at the image below, you can see Ansell has a lower P/E than the average (29.2) in the medical equipment industry classification.
Its relatively low P/E ratio indicates that Ansell shareholders think it will struggle to do as well as other companies in its industry classification. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
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. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining 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).
How Does Ansell's Debt Impact Its P/E Ratio?
Ansell's net debt is 5.8% of its market cap. So it doesn't have as many options as it would with net cash, but its debt would not have much of an impact on its P/E ratio.
The Bottom Line On Ansell's P/E Ratio
Ansell's P/E is 22.4 which is above average (16) in the AU market. With a bit of debt, but a lack of recent growth, it's safe to say the market is expecting improved profit performance from the company, in the next few years.
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 report on the analyst consensus forecasts could help you make a master move on this stock.
You might be able to find a better buy than Ansell. 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).
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 firstname.lastname@example.org. 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.