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Does BAE Systems plc (LON:BA.) Have A Good P/E Ratio?

This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll look at BAE Systems plc's (LON:BA.) P/E ratio and reflect on what it tells us about the company's share price. What is BAE Systems's P/E ratio? Well, based on the last twelve months it is 15.29. That means that at current prices, buyers pay £15.29 for every £1 in trailing yearly profits.

View our latest analysis for BAE Systems

How Do You Calculate BAE Systems's P/E Ratio?

The formula for price to earnings is:

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

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Or for BAE Systems:

P/E of 15.29 = GBP6.35 ÷ GBP0.42 (Based on the year to June 2019.)

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. 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 Does BAE Systems's P/E Ratio Compare To Its Peers?

One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. The image below shows that BAE Systems has a lower P/E than the average (34.1) P/E for companies in the aerospace & defense industry.

LSE:BA. Price Estimation Relative to Market, January 29th 2020
LSE:BA. Price Estimation Relative to Market, January 29th 2020

Its relatively low P/E ratio indicates that BAE Systems shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with BAE Systems, 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.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.

In the last year, BAE Systems grew EPS like Taylor Swift grew her fan base back in 2010; the 82% gain was both fast and well deserved. The sweetener is that the annual five year growth rate of 48% is also impressive. So I'd be surprised if the P/E ratio was not above average.

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. Thus, the metric does not reflect cash or debt held by the company. 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.

BAE Systems's Balance Sheet

Net debt totals just 9.3% of BAE Systems's market cap. It would probably trade on a higher P/E ratio if it had a lot of cash, but I doubt it is having a big impact.

The Verdict On BAE Systems's P/E Ratio

BAE Systems has a P/E of 15.3. That's below the average in the GB market, which is 18.2. 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 have an opportunity when market expectations about a stock are wrong. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

But note: BAE Systems 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).

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.

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. Thank you for reading.