This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at Novartis AG's (VTX:NOVN) P/E ratio and reflect on what it tells us about the company's share price. Based on the last twelve months, Novartis's P/E ratio is 29.72. That means that at current prices, buyers pay CHF29.72 for every CHF1 in trailing yearly profits.

View our latest analysis for Novartis

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

The formula for P/E is:

Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)

Or for Novartis:

P/E of 29.72 = $88.56 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $2.98 (Based on the year to June 2019.)

Is A High P/E 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 Does Novartis's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. You can see in the image below that the average P/E (25.9) for companies in the pharmaceuticals industry is lower than Novartis's P/E.

That means that the market expects Novartis will outperform other companies in its industry. Shareholders are clearly optimistic, but the future is always uncertain. So investors should delve deeper. I like to check if company insiders have been buying or selling.

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. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Novartis shrunk earnings per share by 50% over the last year. But over the longer term (3 years), earnings per share have increased by 2.2%. And it has shrunk its earnings per share by 4.7% per year over the last five years. This growth rate might warrant a below average P/E ratio.

Remember: P/E Ratios Don't Consider The Balance Sheet

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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).

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.

How Does Novartis's Debt Impact Its P/E Ratio?

Novartis has net debt worth just 8.9% of its market capitalization. The market might award it a higher P/E ratio if it had net cash, but its unlikely this low level of net borrowing is having a big impact on the P/E multiple.

The Bottom Line On Novartis's P/E Ratio

Novartis's P/E is 29.7 which is above average (17.6) in its market. With some debt but no EPS growth last year, the market has high expectations of future profits.

Investors have an opportunity when market expectations about a stock are wrong. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.

But note: Novartis may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

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.