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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 Merck & Co., Inc.'s (NYSE:MRK) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, Merck has a P/E ratio of 26.87. In other words, at today's prices, investors are paying $26.87 for every $1 in prior year profit.
How Do You Calculate Merck's P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Merck:
P/E of 26.87 = $85.6 ÷ $3.19 (Based on the year to March 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each $1 the company has earned over the last year. 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
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. Earnings growth means that in the future the 'E' will be higher. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Merck's earnings made like a rocket, taking off 448% last year. The cherry on top is that the five year growth rate was an impressive 16% per year. With that kind of growth rate we would generally expect a high P/E ratio.
Does Merck Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Merck has a higher P/E than the average (19.2) P/E for companies in the pharmaceuticals industry.
Its relatively high P/E ratio indicates that Merck shareholders think it will perform better than other companies in its industry classification. Shareholders are clearly optimistic, but the future is always uncertain. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
Remember: P/E Ratios Don't Consider The Balance Sheet
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. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
So What Does Merck's Balance Sheet Tell Us?
Merck has net debt worth just 7.8% of its market capitalization. So it doesn't have as many options as it would with net cash, but its debt would not have much of an impact on its P/E ratio.
The Verdict On Merck's P/E Ratio
Merck trades on a P/E ratio of 26.9, which is above the US market average of 18.2. Its debt levels do not imperil its balance sheet and its EPS growth is very healthy indeed. So to be frank we are not surprised it has a high P/E ratio.
Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. 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 Merck. 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).
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 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.