Here’s How P/E Ratios Can Help Us Understand Tesco PLC (LON:TSCO)

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This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll apply a basic P/E ratio analysis to Tesco PLC’s (LON:TSCO), to help you decide if the stock is worth further research. Based on the last twelve months, Tesco’s P/E ratio is 17.74. In other words, at today’s prices, investors are paying £17.74 for every £1 in prior year profit.

Check out our latest analysis for Tesco

How Do You Calculate Tesco’s P/E Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for Tesco:

P/E of 17.74 = £2.42 ÷ £0.14 (Based on the year to February 2019.)

Is A High Price-to-Earnings Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. 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. Earnings growth means that in the future the ‘E’ will be higher. 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.

Most would be impressed by Tesco earnings growth of 13% in the last year. And it has improved its earnings per share by 61% per year over the last three years. With that performance, you might expect an above average P/E ratio. In contrast, EPS has decreased by 10%, annually, over 5 years.

Does Tesco Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Tesco has a lower P/E than the average (20.8) P/E for companies in the consumer retailing industry.

LSE:TSCO Price Estimation Relative to Market, May 12th 2019
LSE:TSCO Price Estimation Relative to Market, May 12th 2019

Tesco’s P/E tells us that market participants think it will not fare as well as its peers in the same industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You 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. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its 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.

So What Does Tesco’s Balance Sheet Tell Us?

Tesco has net debt worth 21% of its market capitalization. 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 Tesco’s P/E Ratio

Tesco has a P/E of 17.7. That’s higher than the average in the GB market, which is 16.4. The company is not overly constrained by its modest debt levels, and its recent EPS growth very solid. Therefore, it’s not particularly surprising that it has a above average P/E ratio.

Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth — so investors can make money when fast growth is not fully appreciated. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

But note: Tesco may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

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.