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Despite Its High P/E Ratio, Is MERCK Kommanditgesellschaft auf Aktien (FRA:MRK) Still Undervalued?

Simply Wall St

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This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll look at MERCK Kommanditgesellschaft auf Aktien's (FRA:MRK) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, MERCK Kommanditgesellschaft auf Aktien has a P/E ratio of 43. That corresponds to an earnings yield of approximately 2.3%.

See our latest analysis for MERCK Kommanditgesellschaft auf Aktien

How Do You Calculate MERCK Kommanditgesellschaft auf Aktien's P/E Ratio?

The formula for price to earnings is:

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

Or for MERCK Kommanditgesellschaft auf Aktien:

P/E of 43 = €92.64 ÷ €2.15 (Based on the year to March 2019.)

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. 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 MERCK Kommanditgesellschaft auf Aktien's P/E Ratio Compare To Its Peers?

The P/E ratio indicates whether the market has higher or lower expectations of a company. You can see in the image below that the average P/E (27.6) for companies in the pharmaceuticals industry is lower than MERCK Kommanditgesellschaft auf Aktien's P/E.

DB:MRK Price Estimation Relative to Market, July 10th 2019

MERCK Kommanditgesellschaft auf Aktien'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 further research is always essential. I often monitor director buying and selling.

How Growth Rates Impact P/E Ratios

If earnings fall then in the future the 'E' will be lower. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. Then, a higher P/E might scare off shareholders, pushing the share price down.

MERCK Kommanditgesellschaft auf Aktien shrunk earnings per share by 61% over the last year. And it has shrunk its earnings per share by 5.8% per year over the last five years. This growth rate might warrant a below average P/E ratio.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).

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 Kommanditgesellschaft auf Aktien's Balance Sheet Tell Us?

Net debt totals 17% of MERCK Kommanditgesellschaft auf Aktien's market cap. 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 MERCK Kommanditgesellschaft auf Aktien's P/E Ratio

MERCK Kommanditgesellschaft auf Aktien has a P/E of 43. That's higher than the average in its market, which is 20.1. With a bit of debt, but a lack of recent growth, it's safe to say the market is expecting improved profit performance from the company, in the next few years.

Investors should be looking to buy stocks that the market is wrong about. 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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

Of course you might be able to find a better stock than MERCK Kommanditgesellschaft auf Aktien. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.