Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. 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. Based on the last twelve months, Scotts Miracle-Gro's P/E ratio is 14.07. That is equivalent to an earnings yield of about 7.1%.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Scotts Miracle-Gro:
P/E of 14.07 = USD110.80 ÷ USD7.88 (Based on the trailing twelve months to September 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.
Does Scotts Miracle-Gro Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. If you look at the image below, you can see Scotts Miracle-Gro has a lower P/E than the average (20.8) in the chemicals industry classification.
Its relatively low P/E ratio indicates that Scotts Miracle-Gro shareholders think it will struggle to do as well as other companies in its industry classification. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
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. Earnings growth means that in the future the 'E' will be higher. That means even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
In the last year, Scotts Miracle-Gro grew EPS like Taylor Swift grew her fan base back in 2010; the 247% gain was both fast and well deserved. The cherry on top is that the five year growth rate was an impressive 27% per year. With that kind of growth rate we would generally expect a high P/E ratio.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won't reflect the advantage of cash, or disadvantage of debt. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
How Does Scotts Miracle-Gro's Debt Impact Its P/E Ratio?
Scotts Miracle-Gro's net debt equates to 27% of its market capitalization. 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 has a P/E of 14.1. That's below the average in the US market, which is 18.9. The company hasn't stretched its balance sheet, and earnings growth was good last year. If it continues to grow, then the current low P/E may prove to be unjustified.
When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
But note: Scotts Miracle-Gro 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 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.
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. Thank you for reading.