Should We Worry About Fortescue Metals Group Limited’s (ASX:FMG) 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 Fortescue Metals Group Limited’s (ASX:FMG) P/E ratio to inform your assessment of the investment opportunity. Fortescue Metals Group has a P/E ratio of 17.85, based on the last twelve months. That is equivalent to an earnings yield of about 5.6%.

Check out our latest analysis for Fortescue Metals Group

How Do I Calculate Fortescue Metals Group’s Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for Fortescue Metals Group:

P/E of 17.85 = $4.84 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $0.27 (Based on the year to December 2018.)

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 is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.

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. 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.

Fortescue Metals Group saw earnings per share decrease by 46% last year. But it has grown its earnings per share by 4.2% per year over the last three years. And EPS is down 14% a year, over the last 5 years. This growth rate might warrant a below average P/E ratio.

How Does Fortescue Metals Group’s P/E Ratio Compare To Its Peers?

The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Fortescue Metals Group has a higher P/E than the average (12.3) P/E for companies in the metals and mining industry.

ASX:FMG Price Estimation Relative to Market, March 18th 2019
ASX:FMG Price Estimation Relative to Market, March 18th 2019

Fortescue Metals Group’s P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn’t guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

Don’t forget that the P/E ratio considers market capitalization. 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.

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.

How Does Fortescue Metals Group’s Debt Impact Its P/E Ratio?

Fortescue Metals Group has net debt worth 21% of its market capitalization. That’s enough debt to impact the P/E ratio a little; so keep it in mind if you’re comparing it to companies without debt.

The Verdict On Fortescue Metals Group’s P/E Ratio

Fortescue Metals Group has a P/E of 17.8. That’s higher than the average in the AU market, which is 16.3. With some debt but no EPS growth last year, the market has high expectations of future profits.

Investors have an opportunity when market expectations about a stock are wrong. 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 Fortescue Metals Group. 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).

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.

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. Thank you for reading.