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 Eaton Corporation plc’s (NYSE:ETN) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Eaton’s P/E ratio is 14.07. In other words, at today’s prices, investors are paying $14.07 for every $1 in prior year profit.
How Do I Calculate Eaton’s Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Eaton:
P/E of 14.07 = $69.18 ÷ $4.92 (Based on the year to September 2018.)
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.
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. Earnings growth means that in the future the ‘E’ will be higher. 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.
Eaton shrunk earnings per share by 23% over the last year. But over the longer term (5 years) earnings per share have increased by 12%.
How Does Eaton’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (14.1) for companies in the electrical industry is roughly the same as Eaton’s P/E.
That indicates that the market expects Eaton will perform roughly in line with other companies in its industry. The company could surprise by performing better than average, in the future. I inform my view byby checking management tenure and remuneration, among other things.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn’t take debt or cash into account. 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).
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
Eaton’s Balance Sheet
Eaton’s net debt is 22% of its 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 Eaton’s P/E Ratio
Eaton trades on a P/E ratio of 14.1, which is below the US market average of 16.5. With only modest debt, it’s likely the lack of EPS growth at least partially explains the pessimism implied by the P/E ratio.
When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
Of course you might be able to find a better stock than Eaton. So you may wish to see this free collection of other companies that have grown earnings strongly.
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 email@example.com.