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Should You Be Tempted To Sell Domino's Pizza Enterprises Limited (ASX:DMP) Because Of Its P/E Ratio?

Simply Wall St

The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Domino's Pizza Enterprises Limited's (ASX:DMP), to help you decide if the stock is worth further research. Looking at earnings over the last twelve months, Domino's Pizza Enterprises has a P/E ratio of 36.11. That corresponds to an earnings yield of approximately 2.8%.

View our latest analysis for Domino's Pizza Enterprises

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 Domino's Pizza Enterprises:

P/E of 36.11 = A$48.93 ÷ A$1.36 (Based on the trailing twelve months to June 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each A$1 the company has earned over the last year. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

How Does Domino's Pizza Enterprises's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. As you can see below, Domino's Pizza Enterprises has a higher P/E than the average company (23.5) in the hospitality industry.

ASX:DMP Price Estimation Relative to Market, October 12th 2019

Domino's Pizza Enterprises's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn't guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or 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. 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.

Domino's Pizza Enterprises's earnings per share fell by 2.7% in the last twelve months. But it has grown its earnings per share by 22% per year over the last five years.

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. So it won't reflect the advantage of cash, or disadvantage of debt. 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.

Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.

Domino's Pizza Enterprises's Balance Sheet

Domino's Pizza Enterprises has net debt worth 13% of its market capitalization. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.

The Bottom Line On Domino's Pizza Enterprises's P/E Ratio

Domino's Pizza Enterprises trades on a P/E ratio of 36.1, which is above its market average of 17.9. With some debt but no EPS growth last year, the market has high expectations of future profits.

Investors have an opportunity when market expectations about a stock are wrong. 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 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 editorial-team@simplywallst.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.