This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Quest Diagnostics Incorporated’s (NYSE:DGX) P/E ratio could help you assess the value on offer. Based on the last twelve months, Quest Diagnostics’s P/E ratio is 13.65. That corresponds to an earnings yield of approximately 7.3%.
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How Do I Calculate Quest Diagnostics’s Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Quest Diagnostics:
P/E of 13.65 = $86.15 ÷ $6.31 (Based on the year to September 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each $1 of company earnings. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. 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.
It’s nice to see that Quest Diagnostics grew EPS by a stonking 29% in the last year. And it has bolstered its earnings per share by 4.9% per year over the last five years. I’d therefore be a little surprised if its P/E ratio was not relatively high.
How Does Quest Diagnostics’s P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Quest Diagnostics has a lower P/E than the average (20.6) P/E for companies in the healthcare industry.
This suggests that market participants think Quest Diagnostics will underperform other companies in its industry. Since the market seems unimpressed with Quest Diagnostics, it’s quite possible it could surprise on the upside. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
Remember: P/E Ratios Don’t Consider The Balance Sheet
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. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining cash).
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).
Is Debt Impacting Quest Diagnostics’s P/E?
Quest Diagnostics has net debt worth 30% of its market capitalization. This is enough debt that you’d have to make some adjustments before using the P/E ratio to compare it to a company with net cash.
The Bottom Line On Quest Diagnostics’s P/E Ratio
Quest Diagnostics’s P/E is 13.6 which is below average (16.7) in the US market. 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.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free visual report on analyst forecasts could hold they key to an excellent investment decision.
You might be able to find a better buy than Quest Diagnostics. 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).
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.