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Don't Sell Compass Group PLC (LON:CPG) Before You Read This

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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Compass Group PLC's (LON:CPG), to help you decide if the stock is worth further research. What is Compass Group's P/E ratio? Well, based on the last twelve months it is 25.88. In other words, at today's prices, investors are paying £25.88 for every £1 in prior year profit.

See our latest analysis for Compass Group

How Do You Calculate Compass Group's P/E Ratio?

The formula for price to earnings is:

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

Or for Compass Group:

P/E of 25.88 = £19.12 ÷ £0.74 (Based on the year to March 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each £1 the company has earned over the last year. That isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. 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.

Compass Group's earnings per share grew by -5.1% in the last twelve months. And it has bolstered its earnings per share by 22% per year over the last five years.

Does Compass Group Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio essentially measures market expectations of a company. The image below shows that Compass Group has a higher P/E than the average (17.5) P/E for companies in the hospitality industry.

LSE:CPG Price Estimation Relative to Market, June 17th 2019
LSE:CPG Price Estimation Relative to Market, June 17th 2019

That means that the market expects Compass Group will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So further research is always essential. I often monitor director buying and selling.

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

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. Thus, the metric does not reflect cash or debt held by the company. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.

So What Does Compass Group's Balance Sheet Tell Us?

Compass Group has net debt worth 12% of its market capitalization. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.

The Verdict On Compass Group's P/E Ratio

Compass Group has a P/E of 25.9. That's higher than the average in the GB market, which is 16.2. Given the debt is only modest, and earnings are already moving in the right direction, it's not surprising that the market expects continued improvement.

Investors have an opportunity when market expectations about a stock are wrong. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. 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.

You might be able to find a better buy than Compass Group. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

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.