Here’s How P/E Ratios Can Help Us Understand Novartis AG (VTX:NOVN)

This article is for investors who would like to improve their understanding of 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 P/E ratio of 14.61, based on the last twelve months. That corresponds to an earnings yield of approximately 6.8%.

Check out our latest analysis for Novartis

How Do I Calculate Novartis’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 Novartis:

P/E of 14.61 = $84.27 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $5.77 (Based on the year to September 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. 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. When earnings grow, the ‘E’ increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.

Novartis increased earnings per share by a whopping 103% last year. And it has improved its earnings per share by 21% per year over the last three years. 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?

We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Novartis has a lower P/E than the average (20.4) P/E for companies in the pharmaceuticals industry.

SWX:NOVN PE PEG Gauge December 26th 18
SWX:NOVN PE PEG Gauge December 26th 18

Its relatively low P/E ratio indicates that Novartis shareholders think it will struggle to do as well as other companies in its industry classification. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

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.

Novartis’s Balance Sheet

Novartis has net debt worth just 8.9% 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’s P/E is 14.6 which is below average (17) in the CH market. The EPS growth last year was strong, and debt levels are quite reasonable. If it continues to grow, then the current low P/E may prove to be unjustified.

When the market is wrong about a stock, it gives savvy investors an opportunity. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. 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 Novartis. So you may wish to see this free collection of other companies that have grown earnings strongly.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.