This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). 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 26.55, based on the last twelve months. That corresponds to an earnings yield of approximately 3.8%.
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How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Avery Dennison:
P/E of 26.55 = $93.97 ÷ $3.54 (Based on the year to September 2018.)
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
Earnings growth rates have a big influence on P/E ratios. When earnings grow, the ‘E’ increases, over time. 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.
Avery Dennison shrunk earnings per share by 22% over the last year. But over the longer term (5 years) earnings per share have increased by 9.9%.
How Does Avery Dennison’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (17.1) for companies in the packaging industry is lower than Avery Dennison’s P/E.
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 delve deeper. I like to check if company insiders have been buying or selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
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).
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 Avery Dennison’s Debt Impact Its P/E Ratio?
Net debt totals 21% of Avery Dennison’s market cap. That’s enough debt to impact the P/E ratio a little; so keep it in mind if you’re comparing it to companies without debt.
The Verdict On Avery Dennison’s P/E Ratio
Avery Dennison’s P/E is 26.5 which is above average (16.8) 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.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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 visual report on analyst forecasts could hold they key to an excellent investment decision.
Of course you might be able to find a better stock than Avery Dennison. So you may wish to see this free collection of other companies that have grown earnings strongly.
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 editorial-team@simplywallst.com.