This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Unilever PLC’s (LON:ULVR) P/E ratio could help you assess the value on offer. Unilever has a P/E ratio of 14.12, based on the last twelve months. That means that at current prices, buyers pay £14.12 for every £1 in trailing yearly profits.
How Do I Calculate Unilever’s Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)
Or for Unilever:
P/E of 14.12 = €49.41 (Note: this is the share price in the reporting currency, namely, EUR ) ÷ €3.5 (Based on the year to December 2018.)
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 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.
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. When earnings grow, the ‘E’ increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
Unilever increased earnings per share by a whopping 62% last year. And earnings per share have improved by 10% annually, over the last five years. I’d therefore be a little surprised if its P/E ratio was not relatively high.
How Does Unilever’s P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Unilever has a lower P/E than the average (17.4) P/E for companies in the personal products industry.
Unilever’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 Unilever, it’s quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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.
Is Debt Impacting Unilever’s P/E?
Unilever has net debt worth 16% of its market capitalization. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.
The Verdict On Unilever’s P/E Ratio
Unilever’s P/E is 14.1 which is below average (15.8) in the GB market. The EPS growth last year was strong, and debt levels are quite reasonable. The low P/E ratio suggests current market expectations are muted, implying these levels of growth will not continue.
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.
You might be able to find a better buy than Unilever. 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).
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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. Thank you for reading.