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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We’ll show how you can use Illinois Tool Works Inc.’s (NYSE:ITW) P/E ratio to inform your assessment of the investment opportunity. Looking at earnings over the last twelve months, Illinois Tool Works has a P/E ratio of 19.91. That means that at current prices, buyers pay $19.91 for every $1 in trailing yearly profits.
How Do You Calculate Illinois Tool Works’s P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Illinois Tool Works:
P/E of 19.91 = $150.5 ÷ $7.56 (Based on the trailing twelve months to March 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn’t a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business’s prospects, relative to stocks with a lower P/E.
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. And in that case, the P/E ratio itself will drop rather quickly. Then, a lower P/E should attract more buyers, pushing the share price up.
It’s nice to see that Illinois Tool Works grew EPS by a stonking 44% in the last year. And earnings per share have improved by 15% annually, over the last five years. I’d therefore be a little surprised if its P/E ratio was not relatively high.
How Does Illinois Tool Works’s P/E Ratio Compare To Its Peers?
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 Illinois Tool Works has a P/E ratio that is fairly close for the average for the machinery industry, which is 20.4.
Illinois Tool Works’s P/E tells us that market participants think its prospects are roughly in line with its industry. If the company has better than average prospects, then the market might be underestimating it. I inform my view byby checking management tenure and remuneration, among other things.
Remember: P/E Ratios Don’t Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. 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.
Illinois Tool Works’s Balance Sheet
Illinois Tool Works has net debt worth 12% of its market capitalization. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.
The Bottom Line On Illinois Tool Works’s P/E Ratio
Illinois Tool Works’s P/E is 19.9 which is above average (17.5) in the US market. While the company does use modest debt, its recent earnings growth is superb. So to be frank we are not surprised it has a high 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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
You might be able to find a better buy than Illinois Tool Works. 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).
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 email@example.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.