The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at Pfizer Limited's (NSE:PFIZER) P/E ratio and reflect on what it tells us about the company's share price. Pfizer has a price to earnings ratio of 36.21, based on the last twelve months. That is equivalent to an earnings yield of about 2.8%.

View our latest analysis for Pfizer

How Do I Calculate Pfizer's Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for Pfizer:

P/E of 36.21 = ₹4025.00 ÷ ₹111.15 (Based on the trailing twelve months to September 2019.)

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. 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.

How Does Pfizer's P/E Ratio Compare To Its Peers?

One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. You can see in the image below that the average P/E (16.1) for companies in the pharmaceuticals industry is lower than Pfizer's P/E.

Pfizer'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 delve deeper. I like to check if company insiders have been buying or selling.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.

It's nice to see that Pfizer grew EPS by a stonking 34% in the last year. And it has bolstered its earnings per share by 19% per year over the last five years. I'd therefore be a little surprised if its P/E ratio was not relatively high.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

The 'Price' in P/E reflects the market capitalization of the company. So it won't reflect the advantage of cash, or disadvantage of debt. 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 expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

Pfizer's Balance Sheet

Pfizer has net cash of ₹20b. This is fairly high at 11% of its market capitalization. That might mean balance sheet strength is important to the business, but should also help push the P/E a bit higher than it would otherwise be.

The Bottom Line On Pfizer's P/E Ratio

Pfizer's P/E is 36.2 which is above average (13.3) in its market. Its net cash position is the cherry on top of its superb EPS growth. To us, this is the sort of company that we would expect to carry an above average price tag (relative to earnings).

Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

Of course you might be able to find a better stock than Pfizer. 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.