Despite Its High P/E Ratio, Is Grainger plc (LON:GRI) Still Undervalued?

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 Grainger plc's (LON:GRI), to help you decide if the stock is worth further research. What is Grainger's P/E ratio? Well, based on the last twelve months it is 15.89. That is equivalent to an earnings yield of about 6.3%.

Check out our latest analysis for Grainger

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 Grainger:

P/E of 15.89 = £3.16 ÷ £0.20 (Based on the year to September 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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 Grainger Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio indicates whether the market has higher or lower expectations of a company. As you can see below Grainger has a P/E ratio that is fairly close for the average for the real estate industry, which is 14.8.

Its P/E ratio suggests that Grainger shareholders think that in the future it will perform about the same as other companies in its industry classification. 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

Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the 'E' will be higher. 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.

Grainger saw earnings per share decrease by 5.4% last year. But it has grown its earnings per share by 1.8% per year over the last five years.

Don't Forget: The P/E Does Not Account For Debt or Bank Deposits

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. 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.

While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.

So What Does Grainger's Balance Sheet Tell Us?

Grainger's net debt is 57% of its market cap. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.

The Verdict On Grainger's P/E Ratio

Grainger's P/E is 15.9 which is below average (18.3) in the GB market. The P/E reflects market pessimism that probably arises from the lack of recent EPS growth, paired with significant leverage.

Investors have an opportunity when market expectations about a stock are wrong. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. 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 Grainger. 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 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.