Despite Its High P/E Ratio, Is Avery Dennison Corporation (NYSE:AVY) Still Undervalued?

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Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how Avery Dennison Corporation's (NYSE:AVY) P/E ratio could help you assess the value on offer. Avery Dennison has a price to earnings ratio of 47.25, based on the last twelve months. That is equivalent to an earnings yield of about 2.1%.

View our latest analysis for Avery Dennison

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

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

Or for Avery Dennison:

P/E of 47.25 = $106.83 ÷ $2.26 (Based on the year to March 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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

Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means even if the current P/E is low, it will increase over time if the share price stays flat. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.

Avery Dennison shrunk earnings per share by 32% over the last year. And EPS is down 2.4% a year, over the last 5 years. This growth rate might warrant a below average P/E ratio.

Does Avery Dennison 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 Avery Dennison has a higher P/E than the average (17.6) P/E for companies in the packaging industry.

Its relatively high P/E ratio indicates that Avery Dennison shareholders think it will perform better than other companies in its industry classification. Shareholders are clearly optimistic, but the future is always uncertain. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won't reflect the advantage of cash, or disadvantage of debt. 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).

While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.

So What Does Avery Dennison's Balance Sheet Tell Us?

Avery Dennison's net debt is 22% 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 Avery Dennison's P/E Ratio

Avery Dennison's P/E is 47.2 which is above average (18.2) in the US market. With a bit of debt, but a lack of recent growth, it's safe to say the market is expecting improved profit performance from the company, in the next few years.

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 freevisualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this freelist of companies with modest (or no) debt, trading on a P/E 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.