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Is GlaxoSmithKline plc's (LON:GSK) High P/E Ratio A Problem For Investors?

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 GlaxoSmithKline plc's (LON:GSK) P/E ratio could help you assess the value on offer. What is GlaxoSmithKline's P/E ratio? Well, based on the last twelve months it is 15.50. In other words, at today's prices, investors are paying £15.50 for every £1 in prior year profit.

View our latest analysis for GlaxoSmithKline

How Do You Calculate GlaxoSmithKline's P/E Ratio?

The formula for price to earnings is:

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

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Or for GlaxoSmithKline:

P/E of 15.50 = £16.836 ÷ £1.086 (Based on the year to March 2020.)

(Note: the above calculation results may not be precise due to rounding.)

Is A High Price-to-Earnings 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 Does GlaxoSmithKline's P/E Ratio Compare To Its Peers?

The P/E ratio indicates whether the market has higher or lower expectations of a company. As you can see below GlaxoSmithKline has a P/E ratio that is fairly close for the average for the pharmaceuticals industry, which is 15.7.

LSE:GSK Price Estimation Relative to Market May 29th 2020
LSE:GSK Price Estimation Relative to Market May 29th 2020

Its P/E ratio suggests that GlaxoSmithKline shareholders think that in the future it will perform about the same as other companies in its industry classification. If the company has better than average prospects, then the market might be underestimating it. Further research into factors such as insider buying and selling, could help you form your own view on whether that is likely.

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. When earnings grow, the 'E' increases, over time. And in that case, the P/E ratio itself will drop rather quickly. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

It's nice to see that GlaxoSmithKline grew EPS by a stonking 37% in the last year. And it has improved its earnings per share by 47% per year over the last three years. I'd therefore be a little surprised if its P/E ratio was not relatively high. In contrast, EPS has decreased by 12%, annually, over 5 years.

Don't Forget: The P/E Does Not Account For Debt or Bank Deposits

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. That means it doesn't take debt or cash into account. 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 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.

Is Debt Impacting GlaxoSmithKline's P/E?

GlaxoSmithKline's net debt equates to 31% of its market capitalization. You'd want to be aware of this fact, but it doesn't bother us.

The Bottom Line On GlaxoSmithKline's P/E Ratio

GlaxoSmithKline has a P/E of 15.5. That's around the same as the average in the GB market, which is 14.7. When you consider the impressive EPS growth last year (along with some debt), it seems the market has questions about whether rapid EPS growth will be sustained.

Investors should be looking to buy stocks that the market is wrong about. 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 GlaxoSmithKline. 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).

Love or hate this article? Concerned about the content? Get in touch with us directly. Alternatively, email 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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned. Thank you for reading.