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 AmerisourceBergen Corporation's (NYSE:ABC) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, AmerisourceBergen has a P/E ratio of 22.37. That corresponds to an earnings yield of approximately 4.5%.
How Do I Calculate AmerisourceBergen's Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for AmerisourceBergen:
P/E of 22.37 = USD91.06 ÷ USD4.07 (Based on the trailing twelve months to September 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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 Does AmerisourceBergen's P/E Ratio Compare To Its Peers?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. The image below shows that AmerisourceBergen has a P/E ratio that is roughly in line with the healthcare industry average (23.1).
AmerisourceBergen's P/E tells us that market participants think its prospects are roughly in line with its industry. If the company has better than average prospects, then the market might be underestimating it. Further research into factors such as insider buying and selling, could help you form your own view on whether that is likely.
How Growth Rates Impact P/E Ratios
Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means even if the current P/E is low, it will increase over time if the share price stays flat. Then, a higher P/E might scare off shareholders, pushing the share price down.
AmerisourceBergen shrunk earnings per share by 47% over the last year. But EPS is up 27% over the last 5 years. And it has shrunk its earnings per share by 15% per year over the last three years. This could justify a low P/E.
Remember: P/E Ratios Don't Consider The Balance Sheet
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. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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.
How Does AmerisourceBergen's Debt Impact Its P/E Ratio?
AmerisourceBergen's net debt is 6.0% of its 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 Verdict On AmerisourceBergen's P/E Ratio
AmerisourceBergen trades on a P/E ratio of 22.4, which is above its market average of 19.0. With modest debt but no EPS growth in the last year, it's fair to say the P/E implies some optimism about future earnings, from the market.
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 report on the analyst consensus forecasts could help you make a master move on this stock.
But note: AmerisourceBergen 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 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.
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