Is Zoetis Inc.’s (NYSE:ZTS) High P/E Ratio A Problem For Investors?

Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!

This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll apply a basic P/E ratio analysis to Zoetis Inc.’s (NYSE:ZTS), to help you decide if the stock is worth further research. Looking at earnings over the last twelve months, Zoetis has a P/E ratio of 38.23. That corresponds to an earnings yield of approximately 2.6%.

Check out our latest analysis for Zoetis

How Do You Calculate Zoetis’s P/E Ratio?

The formula for price to earnings is:

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

Or for Zoetis:

P/E of 38.23 = $110.22 ÷ $2.88 (Based on the trailing twelve months to March 2019.)

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. If earnings are growing quickly, then the ‘E’ in the equation will increase faster than it would otherwise. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

It’s nice to see that Zoetis grew EPS by a stonking 44% in the last year. And its annual EPS growth rate over 5 years is 23%. I’d therefore be a little surprised if its P/E ratio was not relatively high.

Does Zoetis Have A Relatively High Or Low P/E For Its Industry?

We can get an indication of market expectations by looking at the P/E ratio. You can see in the image below that the average P/E (17.8) for companies in the pharmaceuticals industry is lower than Zoetis’s P/E.

NYSE:ZTS Price Estimation Relative to Market, June 11th 2019
NYSE:ZTS Price Estimation Relative to Market, June 11th 2019

Zoetis’s P/E tells us that market participants think the company will perform better than its industry peers, going forward. Shareholders are clearly optimistic, but the future is always uncertain. 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

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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 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.

So What Does Zoetis’s Balance Sheet Tell Us?

Zoetis’s net debt is 8.8% of its market cap. The market might award it a higher P/E ratio if it had net cash, but its unlikely this low level of net borrowing is having a big impact on the P/E multiple.

The Bottom Line On Zoetis’s P/E Ratio

Zoetis’s P/E is 38.2 which is above average (17.5) in the US market. The company is not overly constrained by its modest debt levels, and its recent EPS growth is nothing short of stand-out. So on this analysis a high P/E ratio seems reasonable.

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 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 Zoetis. 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 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.