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 AstraZeneca PLC's (LON:AZN) P/E ratio to inform your assessment of the investment opportunity. What is AstraZeneca's P/E ratio? Well, based on the last twelve months it is 58.36. In other words, at today's prices, investors are paying £58.36 for every £1 in prior year profit.
How Do I Calculate AstraZeneca's Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)
Or for AstraZeneca:
P/E of 58.36 = £93.05 (Note: this is the share price in the reporting currency, namely, USD ) ÷ £1.59 (Based on the year to September 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
Does AstraZeneca Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio indicates whether the market has higher or lower expectations of a company. You can see in the image below that the average P/E (20.3) for companies in the pharmaceuticals industry is lower than AstraZeneca's P/E.
That means that the market expects AstraZeneca will outperform other companies in its industry. Shareholders are clearly optimistic, but the future is always uncertain. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
How Growth Rates Impact P/E Ratios
When earnings fall, the 'E' decreases, over time. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.
AstraZeneca's earnings per share fell by 17% in the last twelve months. But EPS is up 14% over the last 5 years. And EPS is down 6.5% a year, over the last 3 years. This might lead to low expectations.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
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).
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.
AstraZeneca's Balance Sheet
AstraZeneca has net debt worth 12% of its market capitalization. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.
The Verdict On AstraZeneca's P/E Ratio
AstraZeneca's P/E is 58.4 which suggests the market is more focussed on the future opportunity rather than the current level of earnings. With modest debt but no EPS growth in the last year, it's fair to say the P/E implies some optimism about future earnings, 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 be able to find a better stock than AstraZeneca. So you may wish to see this free collection of other companies that have grown earnings strongly.
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 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.