In This Article:
Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!
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 Diageo plc's (LON:DGE) P/E ratio could help you assess the value on offer. Diageo has a price to earnings ratio of 28.12, based on the last twelve months. That is equivalent to an earnings yield of about 3.6%.
See our latest analysis for Diageo
How Do I Calculate Diageo's Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Diageo:
P/E of 28.12 = £33.71 ÷ £1.2 (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 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. 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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Diageo saw earnings per share decrease by 6.2% last year. But it has grown its earnings per share by 2.8% per year over the last five years.
Does Diageo 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. You can see in the image below that the average P/E (27.4) for companies in the beverage industry is roughly the same as Diageo's P/E.
Diageo's P/E tells us that market participants think its prospects are roughly in line with its industry. The company could surprise by performing better than average, in the future. Further research into factors such asmanagement tenure, could help you form your own view on whether that is likely.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
Don't forget that the P/E ratio considers market capitalization. That means it doesn't take debt or cash into account. 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).
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).