This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We’ll apply a basic P/E ratio analysis to Cochlear Limited’s (ASX:COH), to help you decide if the stock is worth further research. Based on the last twelve months, Cochlear’s P/E ratio is 35.70. That means that at current prices, buyers pay A$35.70 for every A$1 in trailing yearly profits.
How Do I Calculate Cochlear’s Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Cochlear:
P/E of 35.70 = A$189.020 ÷ A$5.295 (Based on the trailing twelve months to December 2019.)
(Note: the above calculation results may not be precise due to rounding.)
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 a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business’s prospects, relative to stocks with a lower P/E.
How Does Cochlear’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. As you can see below, Cochlear has a higher P/E than the average company (28.9) in the medical equipment industry.
Its relatively high P/E ratio indicates that Cochlear shareholders think it will perform better than other companies in its industry classification. Clearly the market expects growth, but it isn’t guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
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. 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. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
Cochlear increased earnings per share by an impressive 16% over the last twelve months. And it has bolstered its earnings per share by 16% per year over the last five years. With that performance, you might expect an above average P/E ratio.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The ‘Price’ in P/E reflects the market capitalization of the company. 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.
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 Cochlear’s Balance Sheet Tell Us?
Net debt totals just 1.3% of Cochlear’s market cap. So it doesn’t have as many options as it would with net cash, but its debt would not have much of an impact on its P/E ratio.
The Bottom Line On Cochlear’s P/E Ratio
Cochlear’s P/E is 35.7 which is above average (16.2) in its market. While the company does use modest debt, its recent earnings growth is very good. So on this analysis it seems reasonable that its P/E ratio is above average.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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 Cochlear. 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 firstname.lastname@example.org. 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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