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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we’ll show how W.W. Grainger, Inc.’s (NYSE:GWW) P/E ratio could help you assess the value on offer. W.W. Grainger has a P/E ratio of 20.05, based on the last twelve months. In other words, at today’s prices, investors are paying $20.05 for every $1 in prior year profit.
How Do I Calculate W.W. Grainger’s Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for W.W. Grainger:
P/E of 20.05 = $284.85 ÷ $14.2 (Based on the year to March 2019.)
Is A High P/E 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. 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
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. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
W.W. Grainger increased earnings per share by a whopping 27% last year. And earnings per share have improved by 4.5% annually, over the last five years. I’d therefore be a little surprised if its P/E ratio was not relatively high.
Does W.W. Grainger 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, W.W. Grainger has a higher P/E than the average company (16.4) in the trade distributors industry.
W.W. Grainger’s P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn’t guaranteed. So further research is always essential. I often monitor director buying and selling.
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 expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
W.W. Grainger’s Balance Sheet
W.W. Grainger’s net debt is 13% of its market cap. 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 Verdict On W.W. Grainger’s P/E Ratio
W.W. Grainger’s P/E is 20.1 which is above average (18.3) in the US market. 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. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
But note: W.W. Grainger 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 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.