Should You Be Tempted To Sell Aristocrat Leisure Limited (ASX:ALL) Because Of Its P/E Ratio?

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll show how you can use Aristocrat Leisure Limited's (ASX:ALL) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Aristocrat Leisure's P/E ratio is 30.87. That means that at current prices, buyers pay A$30.87 for every A$1 in trailing yearly profits.

Check out our latest analysis for Aristocrat Leisure

How Do You Calculate Aristocrat Leisure's P/E Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Aristocrat Leisure:

P/E of 30.87 = A$33.85 ÷ A$1.10 (Based on the year to September 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that investors are paying a higher price for each A$1 of company 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.

How Does Aristocrat Leisure's P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. The image below shows that Aristocrat Leisure has a higher P/E than the average (24.1) P/E for companies in the hospitality industry.

That means that the market expects Aristocrat Leisure will outperform other companies in its industry.

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.

Notably, Aristocrat Leisure grew EPS by a whopping 29% in the last year. And earnings per share have improved by 40% annually, over the last five years. So we'd generally expect it to have a relatively high P/E ratio. The market might expect further growth, but it isn't guaranteed. So further research is always essential. I often monitor director buying and selling.

Remember: P/E Ratios Don't Consider The Balance Sheet

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. That means it doesn't take debt or cash into account. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

Is Debt Impacting Aristocrat Leisure's P/E?

Aristocrat Leisure's net debt is 10% of its market cap. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.

The Verdict On Aristocrat Leisure's P/E Ratio

Aristocrat Leisure has a P/E of 30.9. That's higher than the average in its market, which is 18.4. 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.

Investors have an opportunity when market expectations about a stock are wrong. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine. 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 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.