Should You Be Tempted To Sell Royal Dutch Shell plc (AMS:RDSA) Because Of Its P/E Ratio?

This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll show how you can use Royal Dutch Shell plc’s (AMS:RDSA) P/E ratio to inform your assessment of the investment opportunity. Royal Dutch Shell has a P/E ratio of 7.21, based on the last twelve months. That means that at current prices, buyers pay €7.21 for every €1 in trailing yearly profits.

Check out our latest analysis for Royal Dutch Shell

How Do I Calculate Royal Dutch Shell’s Price To Earnings Ratio?

The formula for P/E is:

Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)

Or for Royal Dutch Shell:

P/E of 7.21 = $14.174 ÷ $1.966 (Based on the trailing twelve months to December 2019.)

(Note: the above calculation uses the share price in the reporting currency, namely USD and the calculation results may not be precise due to rounding.)

Is A High P/E Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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 Royal Dutch Shell’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. The image below shows that Royal Dutch Shell has a higher P/E than the average (6.6) P/E for companies in the oil and gas industry.

ENXTAM:RDSA Price Estimation Relative to Market, March 16th 2020
ENXTAM:RDSA Price Estimation Relative to Market, March 16th 2020

That means that the market expects Royal Dutch Shell will outperform other companies in its industry. Shareholders are clearly optimistic, but the future is always uncertain. 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

Generally speaking the rate of earnings growth has a profound impact on a company’s P/E multiple. If earnings are growing quickly, then the ‘E’ in the equation will increase faster than it would otherwise. 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.

Royal Dutch Shell shrunk earnings per share by 30% over the last year. But over the longer term (3 years), earnings per share have increased by 50%. And over the longer term (5 years) earnings per share have decreased 3.6% annually. This growth rate might warrant a below average 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. 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.

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).

So What Does Royal Dutch Shell’s Balance Sheet Tell Us?

Royal Dutch Shell has net debt equal to 44% of its market cap. While it’s worth keeping this in mind, it isn’t a worry.

The Bottom Line On Royal Dutch Shell’s P/E Ratio

Royal Dutch Shell trades on a P/E ratio of 7.2, which is below the NL market average of 15.9. With only modest debt, it’s likely the lack of EPS growth at least partially explains the pessimism implied by the P/E ratio.

Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free report on the analyst consensus forecasts could help you make a master move on this stock.

Of course you might be able to find a better stock than Royal Dutch Shell. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.