Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll apply a basic P/E ratio analysis to Tesco PLC's (LON:TSCO), to help you decide if the stock is worth further research. Based on the last twelve months, Tesco's P/E ratio is 19.03. In other words, at today's prices, investors are paying £19.03 for every £1 in prior year profit.
How Do You Calculate Tesco's P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Tesco:
P/E of 19.03 = GBP2.56 ÷ GBP0.13 (Based on the year to August 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each GBP1 of company earnings. 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 Tesco's P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. We can see in the image below that the average P/E (21.1) for companies in the consumer retailing industry is higher than Tesco's P/E.
Tesco's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Many investors like to buy stocks when the market is pessimistic about their prospects. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. When earnings grow, the 'E' increases, over time. That means unless the share price increases, the P/E will reduce in a few years. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Tesco increased earnings per share by a whopping 32% last year. And earnings per share have improved by 7.7% annually, over the last five years. So we'd generally expect it to have a relatively high P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
The 'Price' in P/E reflects the market capitalization of the company. That means it doesn't take debt or cash into account. 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 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.
So What Does Tesco's Balance Sheet Tell Us?
Net debt totals 18% of Tesco's market cap. That's enough debt to impact the P/E ratio a little; so keep it in mind if you're comparing it to companies without debt.
The Verdict On Tesco's P/E Ratio
Tesco trades on a P/E ratio of 19.0, which is fairly close to the GB market average of 18.5. Given it has reasonable debt levels, and grew earnings strongly last year, the P/E indicates the market has doubts this growth can be sustained. Since analysts are predicting growth will continue, one might expect to see a higher P/E so it may be worth looking closer.
Investors have an opportunity when market expectations about a stock are wrong. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.
You might be able to find a better buy than Tesco. 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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