Why Diageo plc's (LON:DGE) High P/E Ratio Isn't Necessarily A Bad Thing

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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.

LSE:DGE Price Estimation Relative to Market, June 7th 2019

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).

Is Debt Impacting Diageo's P/E?

Diageo has net debt worth 13% of its market capitalization. That's enough debt to impact the P/E ratio a little; so keep it in mind if you're comparing it to companies without debt.

The Verdict On Diageo's P/E Ratio

Diageo has a P/E of 28.1. That's higher than the average in the GB market, which is 16.1. With a bit of debt, but a lack of recent growth, it's safe to say the market is expecting improved profit performance from the company, in the next few years.

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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

Of course you might be able to find a better stock than Diageo. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.