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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 Smith & Nephew plc's (LON:SN.) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, Smith & Nephew has a P/E ratio of 28.53. In other words, at today's prices, investors are paying £28.53 for every £1 in prior year profit.
See our latest analysis for Smith & Nephew
How Do I Calculate Smith & Nephew's Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for Smith & Nephew:
P/E of 28.53 = $21.67 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $0.76 (Based on the year to December 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. 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. And in that case, the P/E ratio itself will drop rather quickly. Then, a lower P/E should attract more buyers, pushing the share price up.
Smith & Nephew shrunk earnings per share by 13% over the last year. But EPS is up 4.2% over the last 5 years.
How Does Smith & Nephew's P/E Ratio Compare To Its Peers?
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 (28.5) for companies in the medical equipment industry is roughly the same as Smith & Nephew's P/E.
Its P/E ratio suggests that Smith & Nephew shareholders think that in the future it will perform about the same as other companies in its industry classification. So if Smith & Nephew actually outperforms its peers going forward, that should be a positive for the share price. Further research into factors such as insider buying and selling, could help you form your own view on whether that is likely.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. So it won't reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.