This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at Smith & Nephew plc's (LON:SN.) P/E ratio and reflect on what it tells us about the company's share price. What is Smith & Nephew's P/E ratio? Well, based on the last twelve months it is 30.11. That is equivalent to an earnings yield of about 3.3%.
How Do You Calculate Smith & Nephew's P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for Smith & Nephew:
P/E of 30.11 = £24.04 (Note: this is the share price in the reporting currency, namely, USD ) ÷ £0.80 (Based on the trailing twelve months to June 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 isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
Does Smith & Nephew Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. The image below shows that Smith & Nephew has a P/E ratio that is roughly in line with the medical equipment industry average (32.3).
That indicates that the market expects Smith & Nephew will perform roughly in line with other companies in its industry. The company could surprise by performing better than average, in the future. I would further inform my view by checking insider buying and selling., among other things.
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. And in that case, the P/E ratio itself will drop rather quickly. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Smith & Nephew shrunk earnings per share by 2.9% last year. But EPS is up 6.4% over the last 5 years.
Remember: P/E Ratios Don't Consider The Balance Sheet
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn't take debt or cash into account. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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 Smith & Nephew's Balance Sheet Tell Us?
Net debt totals just 9.0% of Smith & Nephew's market cap. The market might award it a higher P/E ratio if it had net cash, but its unlikely this low level of net borrowing is having a big impact on the P/E multiple.
The Bottom Line On Smith & Nephew's P/E Ratio
Smith & Nephew's P/E is 30.1 which is above average (18.6) in its market. With modest debt but no EPS growth in the last year, it's fair to say the P/E implies some optimism about future earnings, from the market.
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 report on the analyst consensus forecasts could help you make a master move on this stock.
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.
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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