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 Merck & Co Inc’s (NYSE:MRK) P/E ratio could help you assess the value on offer. Based on the last twelve months, Merck’s P/E ratio is 63.74. In other words, at today’s prices, investors are paying $63.74 for every $1 in prior year profit.
How Do You Calculate Merck’s P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Merck:
P/E of 63.74 = $79.34 ÷ $1.24 (Based on the year to September 2018.)
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. That isn’t necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Growth Rates Impact P/E Ratios
If earnings fall then in the future the ‘E’ will be lower. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. A higher P/E should indicate the stock is expensive relative to others — and that may encourage shareholders to sell.
Most would be impressed by Merck earnings growth of 20% in the last year. But earnings per share are down 17% per year over the last five years.
How Does Merck’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. As you can see below, Merck has a much higher P/E than the average company (20.6) in the pharmaceuticals industry.
That means that the market expects Merck will outperform other companies in its industry. Clearly the market expects growth, but it isn’t guaranteed. So further research is always essential. I often monitor director buying and selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The ‘Price’ in P/E reflects the market capitalization of the company. That means it doesn’t take debt or cash into account. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
How Does Merck’s Debt Impact Its P/E Ratio?
Merck’s net debt is 6.5% of its market cap. It would probably trade on a higher P/E ratio if it had a lot of cash, but I doubt it is having a big impact.
The Verdict On Merck’s P/E Ratio
Merck’s P/E is 63.7 which is way above average (18) in the US market. The company is not overly constrained by its modest debt levels, and it is growing earnings per share. So it is not surprising the market is probably extrapolating recent growth well into the future, reflected in the relatively high P/E ratio.
Investors have an opportunity when market expectations about a stock are wrong. 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.
You might be able to find a better buy than Merck. 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.