The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at DS Smith Plc's (LON:SMDS) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, DS Smith has a P/E ratio of 15.89. That means that at current prices, buyers pay £15.89 for every £1 in trailing yearly profits.
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 DS Smith:
P/E of 15.89 = £3.14 ÷ £0.20 (Based on the trailing twelve months to April 2019.)
Is A High Price-to-Earnings Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
How Does DS Smith'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. If you look at the image below, you can see DS Smith has a lower P/E than the average (19.2) in the packaging industry classification.
Its relatively low P/E ratio indicates that DS Smith shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with DS Smith, it's quite possible it could surprise on the upside. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
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. 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. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
DS Smith shrunk earnings per share by 13% over the last year. But EPS is up 5.2% over the last 5 years.
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. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
How Does DS Smith's Debt Impact Its P/E Ratio?
Net debt totals 55% of DS Smith's market cap. This is enough debt that you'd have to make some adjustments before using the P/E ratio to compare it to a company with net cash.
The Bottom Line On DS Smith's P/E Ratio
DS Smith has a P/E of 15.9. That's around the same as the average in the GB market, which is 15.8. With meaningful debt, and no earnings per share growth last year, even an average P/E indicates that the market a significant improvement from the business.
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.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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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. Thank you for reading.