Today, we’ll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we’ll show how Rheinmetall AG’s (FRA:RHM) P/E ratio could help you assess the value on offer. Rheinmetall has a price to earnings ratio of 14.18, based on the last twelve months. In other words, at today’s prices, investors are paying €14.18 for every €1 in prior year profit.
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How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Rheinmetall:
P/E of 14.18 = €103.55 ÷ €7.3 (Based on the year to March 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each €1 the company has earned over the last year. 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 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 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.
Notably, Rheinmetall grew EPS by a whopping 40% in the last year. And it has bolstered its earnings per share by 39% per year over the last five years. I’d therefore be a little surprised if its P/E ratio was not relatively high.
Does Rheinmetall Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. If you look at the image below, you can see Rheinmetall has a lower P/E than the average (27.2) in the industrials industry classification.
Its relatively low P/E ratio indicates that Rheinmetall shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Rheinmetall, it’s quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
Don’t forget that the P/E ratio considers market capitalization. So it won’t reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
How Does Rheinmetall’s Debt Impact Its P/E Ratio?
Rheinmetall has net debt worth just 3.9% of its market capitalization. It would probably trade on a higher P/E ratio if it had a lot of cash, but I doubt it is having a big impact.
The Verdict On Rheinmetall’s P/E Ratio
Rheinmetall has a P/E of 14.2. That’s below the average in the DE market, which is 20.4. The company does have a little debt, and EPS growth was good last year. 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. 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.
You might be able to find a better buy than Rheinmetall. 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).
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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.