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Is Cobham plc's (LON:COB) High P/E Ratio A Problem For Investors?

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 Cobham plc's (LON:COB) P/E ratio could help you assess the value on offer. What is Cobham's P/E ratio? Well, based on the last twelve months it is 36.98. In other words, at today's prices, investors are paying £36.98 for every £1 in prior year profit.

Check out our latest analysis for Cobham

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 Cobham:

P/E of 36.98 = £1.14 ÷ £0.031 (Based on the year to December 2018.)

Is A High P/E Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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 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. And in that case, the P/E ratio itself will drop rather quickly. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

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Cobham's earnings per share fell by 18% in the last twelve months. And it has shrunk its earnings per share by 22% per year over the last five years. This growth rate might warrant a below average P/E ratio.

Does Cobham Have A Relatively High Or Low P/E For Its Industry?

One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. You can see in the image below that the average P/E (21.6) for companies in the aerospace & defense industry is lower than Cobham's P/E.

LSE:COB Price Estimation Relative to Market, April 19th 2019
LSE:COB Price Estimation Relative to Market, April 19th 2019

Cobham's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Shareholders are clearly optimistic, but the future is always uncertain. So investors 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. So it won't reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

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 Cobham's Balance Sheet Tell Us?

The extra options and safety that comes with Cobham's UK£10m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.

The Bottom Line On Cobham's P/E Ratio

Cobham trades on a P/E ratio of 37, which is above the GB market average of 16.3. The recent drop in earnings per share might keep value investors away, but the relatively strong balance sheet will allow the company time to invest in growth. Clearly, the high P/E indicates shareholders think it will!

When the market is wrong about a stock, it gives savvy investors an opportunity. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

But note: Cobham 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).

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.