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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 The Scotts Miracle-Gro Company's (NYSE:SMG) P/E ratio could help you assess the value on offer. Scotts Miracle-Gro has a price to earnings ratio of 16.83, based on the last twelve months. That means that at current prices, buyers pay $16.83 for every $1 in trailing yearly profits.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Scotts Miracle-Gro:
P/E of 16.83 = $94 ÷ $5.58 (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 necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
It's nice to see that Scotts Miracle-Gro grew EPS by a stonking 38% in the last year. And earnings per share have improved by 13% annually, over the last five years. With that performance, I would expect it to have an above average P/E ratio.
How Does Scotts Miracle-Gro's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (17.3) for companies in the chemicals industry is roughly the same as Scotts Miracle-Gro's P/E.
Scotts Miracle-Gro's P/E tells us that market participants think its prospects are roughly in line with its industry. The company could surprise by performing better than average, in the future. 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. Thus, the metric does not reflect cash or debt held by the company. 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.
How Does Scotts Miracle-Gro's Debt Impact Its P/E Ratio?
Net debt is 45% of Scotts Miracle-Gro's market cap. You'd want to be aware of this fact, but it doesn't bother us.
The Verdict On Scotts Miracle-Gro's P/E Ratio
Scotts Miracle-Gro's P/E is 16.8 which is about average (17.5) in the US market. With only modest debt levels, and strong earnings growth, the market seems to doubt that the growth can be maintained. Given analysts are expecting further growth, one might have expected a higher P/E ratio. That may be worth further research.
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 report on the analyst consensus forecasts could help you make a master move on this stock.
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.
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.