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This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we'll show how Aaron Industries Limited's (NSE:AARON) P/E ratio could help you assess the value on offer. Aaron Industries has a price to earnings ratio of 19.34, based on the last twelve months. In other words, at today's prices, investors are paying ₹19.34 for every ₹1 in prior year profit.
View our latest analysis for Aaron Industries
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Aaron Industries:
P/E of 19.34 = ₹48.15 ÷ ₹2.49 (Based on the year to March 2019.)
Is A High Price-to-Earnings 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 Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Aaron Industries's earnings per share fell by 55% in the last twelve months. But over the longer term (5 years) earnings per share have increased by 12%.
How Does Aaron Industries'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 (14.2) for companies in the machinery industry is lower than Aaron Industries's P/E.
Aaron Industries's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn't guaranteed. So further research is always essential. I often monitor director buying and selling.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
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. 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).