The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how Burberry Group plc's (LON:BRBY) P/E ratio could help you assess the value on offer. Burberry Group has a P/E ratio of 25.94, based on the last twelve months. In other words, at today's prices, investors are paying £25.94 for every £1 in prior year profit.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Burberry Group:
P/E of 25.94 = £21.35 ÷ £0.82 (Based on the year to March 2019.)
Is A High P/E 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.'
Does Burberry Group Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. As you can see below, Burberry Group has a higher P/E than the average company (16.9) in the luxury industry.
Burberry Group's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn't guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. 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.
Burberry Group increased earnings per share by an impressive 19% over the last twelve months. And earnings per share have improved by 2.2% annually, over the last five years. So one might expect an above average P/E ratio.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. 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 Burberry Group's Debt Impact Its P/E Ratio?
Since Burberry Group holds net cash of UK£837m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Burberry Group's P/E Ratio
Burberry Group trades on a P/E ratio of 25.9, which is above its market average of 15.8. Its net cash position supports a higher P/E ratio, as does its solid recent earnings growth. So it is not surprising the market is probably extrapolating recent growth well into the future, reflected in the relatively high P/E ratio.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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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.