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This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at Jazz Pharmaceuticals plc's (NASDAQ:JAZZ) P/E ratio and reflect on what it tells us about the company's share price. Jazz Pharmaceuticals has a P/E ratio of 17.47, based on the last twelve months. That corresponds to an earnings yield of approximately 5.7%.
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 Jazz Pharmaceuticals:
P/E of 17.47 = $143.24 ÷ $8.2 (Based on the trailing twelve months to March 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Jazz Pharmaceuticals increased earnings per share by an impressive 10% over the last twelve months. And it has bolstered its earnings per share by 43% per year over the last five years. This could arguably justify a relatively high P/E ratio.
How Does Jazz Pharmaceuticals's P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. If you look at the image below, you can see Jazz Pharmaceuticals has a lower P/E than the average (19.1) in the pharmaceuticals industry classification.
This suggests that market participants think Jazz Pharmaceuticals will underperform other companies in its industry. Since the market seems unimpressed with Jazz Pharmaceuticals, it's quite possible it could surprise on the upside. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. 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 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.
Is Debt Impacting Jazz Pharmaceuticals's P/E?
Net debt totals just 9.4% of Jazz Pharmaceuticals's market cap. It would probably trade on a higher P/E ratio if it had a lot of cash, but I doubt it is having a big impact.
The Bottom Line On Jazz Pharmaceuticals's P/E Ratio
Jazz Pharmaceuticals trades on a P/E ratio of 17.5, which is fairly close to the US market average of 18.2. Given it has reasonable debt levels, and grew earnings strongly last year, the P/E indicates the market has doubts this growth can be sustained.
Investors have an opportunity when market expectations about a stock are wrong. 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: Jazz Pharmaceuticals 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).
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 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. Thank you for reading.