The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to GlaxoSmithKline plc's (LON:GSK), to help you decide if the stock is worth further research. Looking at earnings over the last twelve months, GlaxoSmithKline has a P/E ratio of 19.47. That is equivalent to an earnings yield of about 5.1%.
See our latest analysis for GlaxoSmithKline
How Do You Calculate GlaxoSmithKline's P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for GlaxoSmithKline:
P/E of 19.47 = £17.97 ÷ £0.92 (Based on the trailing twelve months to September 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. 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.
Does GlaxoSmithKline 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. As you can see below GlaxoSmithKline has a P/E ratio that is fairly close for the average for the pharmaceuticals industry, which is 20.2.
GlaxoSmithKline's P/E tells us that market participants think its prospects are roughly in line with its industry. The company could surprise by performing better than average, in the future. I would further inform my view by checking insider buying and selling., among other things.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. When earnings grow, the 'E' increases, over time. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
GlaxoSmithKline's 143% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. Even better, EPS is up 146% per year over three years. So we'd absolutely expect it to have a relatively high P/E ratio.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
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. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
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 GlaxoSmithKline's Debt Impact Its P/E Ratio?
GlaxoSmithKline has net debt equal to 32% of its market cap. You'd want to be aware of this fact, but it doesn't bother us.
The Verdict On GlaxoSmithKline's P/E Ratio
GlaxoSmithKline has a P/E of 19.5. That's around the same as the average in the GB market, which is 18.3. When you consider the impressive EPS growth last year (along with some debt), it seems the market has questions about whether rapid EPS growth will be sustained.
Investors have an opportunity when market expectations about a stock are wrong. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. 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 GlaxoSmithKline. 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).
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.
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