Medtronic (NYSE:MDT) shareholders are no doubt pleased to see that the share price has bounced 33% in the last month alone, although it is still down 13% over the last quarter. The full year gain of 23% is pretty reasonable, too.
Assuming no other changes, a sharply higher share price makes a stock less attractive to potential buyers. While the market sentiment towards a stock is very changeable, in the long run, the share price will tend to move in the same direction as earnings per share. The implication here is that deep value investors might steer clear when expectations of a company are too high. One way to gauge market expectations of a stock is to look at its Price to Earnings Ratio (PE Ratio). A high P/E ratio means that investors have a high expectation about future growth, while a low P/E ratio means they have low expectations about future growth.
Does Medtronic Have A Relatively High Or Low P/E For Its Industry?
Medtronic's P/E of 25.62 indicates relatively low sentiment towards the stock. The image below shows that Medtronic has a lower P/E than the average (44.7) P/E for companies in the medical equipment industry.
Medtronic's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Since the market seems unimpressed with Medtronic, it's quite possible it could surprise on the upside. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Most would be impressed by Medtronic earnings growth of 14% in the last year. And earnings per share have improved by 5.0% annually, over the last five years. With that performance, you might expect an above average P/E ratio.
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. 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.
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.
So What Does Medtronic's Balance Sheet Tell Us?
Net debt totals 10% of Medtronic's market cap. That's enough debt to impact the P/E ratio a little; so keep it in mind if you're comparing it to companies without debt.
The Verdict On Medtronic's P/E Ratio
Medtronic trades on a P/E ratio of 25.6, which is above its market average of 13.6. Its debt levels do not imperil its balance sheet and it is growing EPS strongly. Therefore, it's not particularly surprising that it has a above average P/E ratio. What is very clear is that the market has become significantly more optimistic about Medtronic over the last month, with the P/E ratio rising from 19.2 back then to 25.6 today. For those who prefer to invest with the flow of momentum, that might mean it's time to put the stock on a watchlist, or research it. But the contrarian may see it as a missed opportunity.
Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine. 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.
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.
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.
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