Why ABB Ltd's (VTX:ABBN) High P/E Ratio Isn't Necessarily A Bad Thing

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at ABB Ltd's (VTX:ABBN) P/E ratio and reflect on what it tells us about the company's share price. ABB has a P/E ratio of 28.24, based on the last twelve months. That means that at current prices, buyers pay CHF28.24 for every CHF1 in trailing yearly profits.

See our latest analysis for ABB

How Do I Calculate ABB's Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for ABB:

P/E of 28.24 = $19.21 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $0.68 (Based on the trailing twelve months to December 2018.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each CHF1 the company has earned over the last year. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.'

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. 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.

ABB's earnings per share fell by 34% in the last twelve months. But EPS is up 4.7% over the last 3 years. And over the longer term (5 years) earnings per share have decreased 4.9% annually. This could justify a pessimistic P/E.

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

The P/E ratio essentially measures market expectations of a company. The image below shows that ABB has a higher P/E than the average (19.2) P/E for companies in the electrical industry.

That means that the market expects ABB will outperform other companies in its industry. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

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

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining cash).

Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.

How Does ABB's Debt Impact Its P/E Ratio?

Net debt totals 11% of ABB's market cap. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.

The Bottom Line On ABB's P/E Ratio

ABB's P/E is 28.2 which is above average (17.9) in the CH market. With a bit of debt, but a lack of recent growth, it's safe to say the market is expecting improved profit performance from the company, in the next few years.

Investors should be looking to buy stocks that the market is wrong about. 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 freevisual report on analyst forecasts could hold the key to an excellent investment decision.

You might be able to find a better buy than ABB. If you want a selection of possible winners, check out this freelist 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.