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This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Novo Nordisk A/S's (CPH:NOVO B), to help you decide if the stock is worth further research. Looking at earnings over the last twelve months, Novo Nordisk has a P/E ratio of 20.11. That means that at current prices, buyers pay DKK20.11 for every DKK1 in trailing yearly profits.
How Do You Calculate Novo Nordisk's P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Novo Nordisk:
P/E of 20.11 = DKK320 ÷ DKK15.92 (Based on the trailing twelve months to March 2019.)
Is A High Price-to-Earnings Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing 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. When earnings grow, the 'E' increases, over time. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Novo Nordisk maintained roughly steady earnings over the last twelve months. But over the longer term (5 years) earnings per share have increased by 11%.
Does Novo Nordisk Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. As you can see below Novo Nordisk has a P/E ratio that is fairly close for the average for the pharmaceuticals industry, which is 21.5.
Its P/E ratio suggests that Novo Nordisk shareholders think that in the future it will perform about the same as other companies in its industry classification. So if Novo Nordisk actually outperforms its peers going forward, that should be a positive for the share price. Checking factors such as the tenure of the board and management could help you form your own view on if that will happen.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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.
While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
Novo Nordisk's Balance Sheet
Novo Nordisk has net cash of ø4.7b. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Verdict On Novo Nordisk's P/E Ratio
Novo Nordisk has a P/E of 20.1. That's higher than the average in the DK market, which is 16.7. Recent earnings growth wasn't bad. And the net cash position provides the company with multiple options. The high P/E suggests the market thinks further growth will come.
Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
You might be able to find a better buy than Novo Nordisk. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
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 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.