This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we'll show how Ferguson plc's (LON:FERG) P/E ratio could help you assess the value on offer. Based on the last twelve months, Ferguson's P/E ratio is 18.86. In other words, at today's prices, investors are paying £18.86 for every £1 in prior year profit.
How Do You Calculate Ferguson's P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)
Or for Ferguson:
P/E of 18.86 = £86.93 (Note: this is the share price in the reporting currency, namely, USD ) ÷ £4.61 (Based on the year to July 2019.)
Is A High P/E 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. 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 Does Ferguson's P/E Ratio Compare To Its Peers?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. You can see in the image below that the average P/E (15.5) for companies in the trade distributors industry is lower than Ferguson's P/E.
That means that the market expects Ferguson will outperform other companies in its industry. Shareholders are clearly optimistic, but the future is always uncertain. So further research is always essential. I often monitor director buying and selling.
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. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.
It's nice to see that Ferguson grew EPS by a stonking 28% in the last year. And earnings per share have improved by 7.3% annually, over the last five years. I'd therefore be a little surprised if its P/E ratio was not relatively high.
Remember: P/E Ratios Don't Consider The Balance Sheet
The 'Price' in P/E reflects the market capitalization of the company. So it won't reflect the advantage of cash, or disadvantage of debt. 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).
How Does Ferguson's Debt Impact Its P/E Ratio?
Ferguson's net debt is 6.1% of its market cap. The market might award it a higher P/E ratio if it had net cash, but its unlikely this low level of net borrowing is having a big impact on the P/E multiple.
The Bottom Line On Ferguson's P/E Ratio
Ferguson trades on a P/E ratio of 18.9, which is above its market average of 17.1. The company is not overly constrained by its modest debt levels, and its recent EPS growth very solid. Therefore, it's not particularly surprising that it has a above average P/E ratio.
When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course you might be able to find a better stock than Ferguson. So you may wish to see this free collection of other companies that have grown earnings strongly.
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.
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