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Should You Be Tempted To Sell Severn Trent Plc (LON:SVT) Because Of Its P/E Ratio?

Victor Youngblood

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We’ll look at Severn Trent Plc’s (LON:SVT) P/E ratio and reflect on what it tells us about the company’s share price. Severn Trent has a P/E ratio of 16.52, based on the last twelve months. In other words, at today’s prices, investors are paying £16.52 for every £1 in prior year profit.

Check out our latest analysis for Severn Trent

How Do I Calculate A Price To Earnings Ratio?

The formula for P/E is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Severn Trent:

P/E of 16.52 = £18.16 ÷ £1.1 (Based on the trailing twelve months to September 2018.)

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.

Severn Trent’s earnings per share fell by 8.8% in the last twelve months. And over the longer term (5 years) earnings per share have decreased 6.3% annually. So you wouldn’t expect a very high P/E.

How Does Severn Trent’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, Severn Trent has a higher P/E than the average company (12.9) in the water utilities industry.

LSE:SVT PE PEG Gauge January 2nd 19

Its relatively high P/E ratio indicates that Severn Trent shareholders think it will perform better than other companies in its industry classification. Shareholders are clearly optimistic, but the future is always uncertain. So further research is always essential. I often monitor director buying and selling.

Remember: P/E Ratios Don’t Consider The Balance Sheet

The ‘Price’ in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. 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).

Is Debt Impacting Severn Trent’s P/E?

Net debt totals a substantial 129% of Severn Trent’s market cap. This is a relatively high level of debt, so the stock probably deserves a relatively low P/E ratio. Keep that in mind when comparing it to other companies.

The Verdict On Severn Trent’s P/E Ratio

Severn Trent has a P/E of 16.5. That’s higher than the average in the GB market, which is 14.9. With relatively high debt, and no earnings per share growth over twelve months, it’s safe to say the market believes the company will improve its earnings growth in the future.

Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free report on the analyst consensus forecasts could help you make a master move on this stock.

You might be able to find a better buy than Severn Trent. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.