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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 Ramkrishna Forgings Limited's (NSE:RKFORGE) P/E ratio could help you assess the value on offer. Ramkrishna Forgings has a price to earnings ratio of 12.13, based on the last twelve months. In other words, at today's prices, investors are paying ₹12.13 for every ₹1 in prior year profit.
Check out our latest analysis for Ramkrishna Forgings
How Do You Calculate Ramkrishna Forgings's P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Ramkrishna Forgings:
P/E of 12.13 = ₹447 ÷ ₹36.85 (Based on the trailing twelve months to March 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each ₹1 of company earnings. 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 Does Ramkrishna Forgings'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 (8.5) for companies in the metals and mining industry is lower than Ramkrishna Forgings's P/E.
That means that the market expects Ramkrishna Forgings will outperform other companies in its industry. 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
Earnings growth rates have a big influence on P/E ratios. When earnings grow, the 'E' increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.
Ramkrishna Forgings increased earnings per share by an impressive 22% over the last twelve months. And earnings per share have improved by 62% annually, over the last five years. This could arguably justify a relatively high 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. 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.