The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at Wesfarmers Limited's (ASX:WES) P/E ratio and reflect on what it tells us about the company's share price. Wesfarmers has a P/E ratio of 24.39, based on the last twelve months. That corresponds to an earnings yield of approximately 4.1%.
How Do You Calculate Wesfarmers's P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Wesfarmers:
P/E of 24.39 = A$41.84 ÷ A$1.72 (Based on the trailing twelve months to June 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each A$1 the company has earned over the last year. That isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
Does Wesfarmers Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. The image below shows that Wesfarmers has a higher P/E than the average (17.7) P/E for companies in the multiline retail industry.
Its relatively high P/E ratio indicates that Wesfarmers shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn't guarantee future growth. 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. When earnings grow, the 'E' increases, over time. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Notably, Wesfarmers grew EPS by a whopping 38% in the last year. And earnings per share have improved by 5.0% annually, over the last five years. With that performance, I would expect it to have an above average P/E ratio.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
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.
Wesfarmers's Balance Sheet
Net debt totals just 4.8% of Wesfarmers's 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 Wesfarmers's P/E Ratio
Wesfarmers has a P/E of 24.4. That's higher than the average in its market, which is 18.7. Its debt levels do not imperil its balance sheet and its EPS growth is very healthy indeed. So on this analysis a high P/E ratio seems reasonable.
Investors should be looking to buy stocks that the market is wrong about. 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 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.
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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