Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at Barratt Developments PLC's (LON:BDEV) P/E ratio and reflect on what it tells us about the company's share price. Based on the last twelve months, Barratt Developments's P/E ratio is 10.20. That means that at current prices, buyers pay £10.20 for every £1 in trailing yearly profits.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Barratt Developments:
P/E of 10.20 = £7.47 ÷ £0.73 (Based on the year to June 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. 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 Barratt Developments'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. We can see in the image below that the average P/E (12.1) for companies in the consumer durables industry is higher than Barratt Developments's P/E.
Barratt Developments'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 Barratt Developments, it's quite possible it could surprise on the upside. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
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. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.
It's great to see that Barratt Developments grew EPS by 10% in the last year. And it has bolstered its earnings per share by 19% per year over the last five years. So one might expect an above average P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
How Does Barratt Developments's Debt Impact Its P/E Ratio?
Since Barratt Developments holds net cash of UK£758m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Bottom Line On Barratt Developments's P/E Ratio
Barratt Developments's P/E is 10.2 which is below average (17.9) in the GB market. It grew its EPS nicely over the last year, and the healthy balance sheet implies there is more potential for growth. The relatively low P/E ratio implies the market is pessimistic.
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 report on the analyst consensus forecasts could help you make a master move on this stock.
You might be able to find a better buy than Barratt Developments. 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).
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.
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