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 Cadsys (India) Limited's (NSE:CADSYS) P/E ratio could help you assess the value on offer. What is Cadsys (India)'s P/E ratio? Well, based on the last twelve months it is 2.87. That is equivalent to an earnings yield of about 34.8%.

Check out our latest analysis for Cadsys (India)

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for Cadsys (India):

P/E of 2.87 = ₹47.50 ÷ ₹16.55 (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 isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.

Does Cadsys (India) Have A Relatively High Or Low P/E For Its Industry?

We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Cadsys (India) has a lower P/E than the average (11.3) P/E for companies in the professional services industry.

Its relatively low P/E ratio indicates that Cadsys (India) shareholders think it will struggle to do as well as other companies in its industry classification. Many investors like to buy stocks when the market is pessimistic about their prospects. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. And in that case, the P/E ratio itself will drop rather quickly. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

Cadsys (India) increased earnings per share by a whopping 44% last year. And its annual EPS growth rate over 5 years is 25%. I'd therefore be a little surprised if its P/E ratio was not relatively high.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

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 Cadsys (India)'s Balance Sheet Tell Us?

Cadsys (India) has net cash of ₹124m. This is fairly high at 35% of its market capitalization. That might mean balance sheet strength is important to the business, but should also help push the P/E a bit higher than it would otherwise be.

The Verdict On Cadsys (India)'s P/E Ratio

Cadsys (India) has a P/E of 2.9. That's below the average in the IN market, which is 13.1. Not only should the net cash position reduce risk, but the recent growth has been impressive. The relatively low P/E ratio implies the market is pessimistic.

When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. We don't have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.

Of course you might be able to find a better stock than Cadsys (India). So you may wish to see this free collection of other companies that have grown earnings strongly.

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.