The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We’ll look at Pokarna Limited’s (NSE:POKARNA) P/E ratio and reflect on what it tells us about the company’s share price. Pokarna has a P/E ratio of 8.47, based on the last twelve months. That is equivalent to an earnings yield of about 12%.

See our latest analysis for Pokarna

How Do You Calculate A P/E Ratio?

The formula for P/E is:

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

Or for Pokarna:

P/E of 8.47 = ₹157.4 ÷ ₹18.58 (Based on the year to September 2018.)

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 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

Companies that shrink earnings per share quickly will rapidly decrease the ‘E’ in the equation. That means even if the current P/E is low, it will increase over time if the share price stays flat. Then, a higher P/E might scare off shareholders, pushing the share price down.

Pokarna increased earnings per share by an impressive 17% over the last twelve months. And it has bolstered its earnings per share by 13% per year over the last five years. So one might expect an above average P/E ratio. Unfortunately, earnings per share are down 5.2% a year, over 3 years.

How Does Pokarna’s P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. We can see in the image below that the average P/E (19.2) for companies in the basic materials industry is higher than Pokarna’s P/E.

Its relatively low P/E ratio indicates that Pokarna shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Pokarna, it’s quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.

Remember: P/E Ratios Don’t Consider The Balance Sheet

The ‘Price’ in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).