This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Kalyani Steels Limited's (NSE:KSL), to help you decide if the stock is worth further research. Kalyani Steels has a price to earnings ratio of 6.10, based on the last twelve months. That is equivalent to an earnings yield of about 16.4%.

See our latest analysis for Kalyani Steels

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

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

Or for Kalyani Steels:

P/E of 6.10 = ₹195.80 ÷ ₹32.12 (Based on the year to June 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 a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.

Does Kalyani Steels Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio indicates whether the market has higher or lower expectations of a company. If you look at the image below, you can see Kalyani Steels has a lower P/E than the average (8.8) in the metals and mining industry classification.

Kalyani Steels's P/E tells us that market participants think it will not fare as well as its peers in the same industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. 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

Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. Earnings growth means that in the future the 'E' will be higher. And in that case, the P/E ratio itself will drop rather quickly. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

It's great to see that Kalyani Steels grew EPS by 17% in the last year. And its annual EPS growth rate over 5 years is 17%. This could arguably justify a relatively high P/E ratio.

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. So it won't reflect the advantage of cash, or disadvantage of debt. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

So What Does Kalyani Steels's Balance Sheet Tell Us?

Kalyani Steels has net cash of ₹2.2b. This is fairly high at 25% 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 Bottom Line On Kalyani Steels's P/E Ratio

Kalyani Steels trades on a P/E ratio of 6.1, which is below the IN market average of 13.8. It grew its EPS nicely over the last year, and the healthy balance sheet implies there is more potential for growth. One might conclude that the market is a bit pessimistic, given the low P/E ratio.

Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine. We don't have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.

But note: Kalyani Steels may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

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.