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Do You Know What Eaton Corporation plc's (NYSE:ETN) P/E Ratio Means?

Simply Wall St

The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Eaton Corporation plc's (NYSE:ETN), to help you decide if the stock is worth further research. Based on the last twelve months, Eaton's P/E ratio is 16.84. In other words, at today's prices, investors are paying $16.84 for every $1 in prior year profit.

Check out our latest analysis for Eaton

How Do I Calculate Eaton's Price To Earnings Ratio?

The formula for P/E is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Eaton:

P/E of 16.84 = $95.16 ÷ $5.65 (Based on the trailing twelve months to September 2019.)

Is A High P/E Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing 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'.

How Does Eaton's P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. We can see in the image below that the average P/E (19.0) for companies in the electrical industry is higher than Eaton's P/E.

NYSE:ETN Price Estimation Relative to Market, January 6th 2020
NYSE:ETN Price Estimation Relative to Market, January 6th 2020

Its relatively low P/E ratio indicates that Eaton shareholders think it will struggle to do as well as other companies in its industry classification. Many investors like to buy stocks when the market is pessimistic about their prospects. You should delve deeper. I like to check if company insiders have been buying or selling.

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. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. And in that case, the P/E ratio itself will drop rather quickly. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

It's great to see that Eaton grew EPS by 15% in the last year. And its annual EPS growth rate over 5 years is 9.7%. So one might expect an above average P/E ratio.

Remember: P/E Ratios Don't Consider The Balance Sheet

The 'Price' in P/E reflects the market capitalization of the company. 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.

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 Eaton's Debt Impact Its P/E Ratio?

Eaton's net debt is 18% of its market cap. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.

The Bottom Line On Eaton's P/E Ratio

Eaton's P/E is 16.8 which is below average (18.9) in the US market. The company hasn't stretched its balance sheet, and earnings growth was good last year. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.

Investors should be looking to buy stocks that the market is wrong about. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. 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.

But note: Eaton may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.

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. Thank you for reading.