Why Westpac Banking Corporation's (ASX:WBC) High P/E Ratio Isn't Necessarily A Bad Thing

Simply Wall St

Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use Westpac Banking Corporation's (ASX:WBC) P/E ratio to inform your assessment of the investment opportunity. Westpac Banking has a price to earnings ratio of 13.14, based on the last twelve months. That means that at current prices, buyers pay A$13.14 for every A$1 in trailing yearly profits.

Check out our latest analysis for Westpac Banking

How Do I Calculate Westpac Banking's Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for Westpac Banking:

P/E of 13.14 = AUD25.81 ÷ AUD1.96 (Based on the year to September 2019.)

Is A High Price-to-Earnings Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. 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 Westpac Banking's P/E Ratio Compare To Its Peers?

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 (12.2) for companies in the banks industry is lower than Westpac Banking's P/E.

ASX:WBC Price Estimation Relative to Market, February 21st 2020

Westpac Banking's P/E tells us that market participants think the company will perform better than its industry peers, going forward. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should delve deeper. I like to check if company insiders have been buying or selling.

How Growth Rates Impact P/E Ratios

When earnings fall, the 'E' decreases, over time. That means even if the current P/E is low, it will increase over time if the share price stays flat. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.

Westpac Banking shrunk earnings per share by 17% over the last year. And over the longer term (5 years) earnings per share have decreased 4.1% annually. 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. 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.

Is Debt Impacting Westpac Banking's P/E?

Net debt totals a substantial 176% of Westpac Banking's market cap. This level of debt justifies a relatively low P/E, so remain cognizant of the debt, if you're comparing it to other stocks.

The Verdict On Westpac Banking's P/E Ratio

Westpac Banking has a P/E of 13.1. That's below the average in the AU market, which is 18.6. When you consider that the company has significant debt, and didn't grow EPS last year, it isn't surprising that the market has muted expectations.

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 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 find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

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.

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.