This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We’ll look at Novartis AG’s (VTX:NOVN) P/E ratio and reflect on what it tells us about the company’s share price. Novartis has a price to earnings ratio of 17.7, based on the last twelve months. That is equivalent to an earnings yield of about 5.7%.
How Do You Calculate Novartis’s P/E 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 Novartis:
P/E of 17.7 = $96.23 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $5.44 (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 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 Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.
It’s nice to see that Novartis grew EPS by a stonking 66% in the last year. And its annual EPS growth rate over 5 years is 3.5%. I’d therefore be a little surprised if its P/E ratio was not relatively high.
How Does Novartis’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 Novartis has a lower P/E than the average (22.6) P/E for companies in the pharmaceuticals industry.
This suggests that market participants think Novartis will underperform other companies in its industry. Since the market seems unimpressed with Novartis, it’s quite possible it could surprise on the upside. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The ‘Price’ in P/E reflects the market capitalization of the company. 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 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.
Is Debt Impacting Novartis’s P/E?
Novartis has net debt worth just 7.3% of its market capitalization. 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 Novartis’s P/E Ratio
Novartis trades on a P/E ratio of 17.7, which is fairly close to the CH market average of 18.1. Given it has reasonable debt levels, and grew earnings strongly last year, the P/E indicates the market has doubts this growth can be sustained.
Investors should be looking to buy stocks that the market is wrong about. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course you might be able to find a better stock than Novartis. So you may wish to see this free collection of other companies that have grown earnings strongly.
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 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. Thank you for reading.