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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how LT Foods Limited's (NSE:DAAWAT) P/E ratio could help you assess the value on offer. Based on the last twelve months, LT Foods's P/E ratio is 5.21. In other words, at today's prices, investors are paying ₹5.21 for every ₹1 in prior year profit.
See our latest analysis for LT Foods
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for LT Foods:
P/E of 5.21 = ₹20.65 ÷ ₹3.96 (Based on the trailing twelve months to March 2019.)
Is A High P/E 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 Does LT Foods's P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. We can see in the image below that the average P/E (16) for companies in the food industry is higher than LT Foods's P/E.
This suggests that market participants think LT Foods will underperform other companies in its industry. Many investors like to buy stocks when the market is pessimistic about their prospects. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. 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. Then, a lower P/E should attract more buyers, pushing the share price up.
LT Foods's earnings per share fell by 17% in the last twelve months. But over the longer term (5 years) earnings per share have increased by 5.8%.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
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. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.