This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll show how you can use Associated British Foods plc's (LON:ABF) P/E ratio to inform your assessment of the investment opportunity. Looking at earnings over the last twelve months, Associated British Foods has a P/E ratio of 23.95. That is equivalent to an earnings yield of about 4.2%.
How Do You Calculate Associated British Foods's P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Associated British Foods:
P/E of 23.95 = GBP26.61 ÷ GBP1.11 (Based on the trailing twelve months to September 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each GBP1 the company has earned over the last year. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price'.
Does Associated British Foods Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. The image below shows that Associated British Foods has a higher P/E than the average (16.6) P/E for companies in the food industry.
Associated British Foods's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn't guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. When earnings grow, the 'E' increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Associated British Foods's earnings per share fell by 13% in the last twelve months. But EPS is up 2.9% over the last 5 years.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
The 'Price' in P/E reflects the market capitalization of the company. 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.
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).
So What Does Associated British Foods's Balance Sheet Tell Us?
Associated British Foods has net cash of UK£950m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Bottom Line On Associated British Foods's P/E Ratio
Associated British Foods trades on a P/E ratio of 24.0, which is above its market average of 18.5. Falling earnings per share is probably keeping traditional value investors away, but the net cash position means the company has time to improve: and the high P/E suggests the market thinks it will.
Investors should be looking to buy stocks that the market is wrong about. 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.
Of course you might be able to find a better stock than Associated British Foods. So you may wish to see this free collection of other companies that have grown earnings strongly.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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. Thank you for reading.