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 Thirumalai Chemicals Limited's (NSE:TIRUMALCHM) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, Thirumalai Chemicals has a P/E ratio of 6.68. That is equivalent to an earnings yield of about 15%.

See our latest analysis for Thirumalai Chemicals

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 Thirumalai Chemicals:

P/E of 6.68 = ₹61.5 ÷ ₹9.21 (Based on the year to June 2019.)

Is A High Price-to-Earnings Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. 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 Does Thirumalai Chemicals's P/E Ratio Compare To Its Peers?

One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. The image below shows that Thirumalai Chemicals has a lower P/E than the average (11.3) P/E for companies in the chemicals industry.

Thirumalai Chemicals'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. 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

Probably the most important factor in determining what P/E a company trades on is the earnings growth. Earnings growth means that in the future the 'E' will be higher. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Thirumalai Chemicals shrunk earnings per share by 44% over the last year. But it has grown its earnings per share by 48% per year over the last five years.

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. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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).

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.

How Does Thirumalai Chemicals's Debt Impact Its P/E Ratio?

Thirumalai Chemicals has net cash of ₹96m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.

The Bottom Line On Thirumalai Chemicals's P/E Ratio

Thirumalai Chemicals trades on a P/E ratio of 6.7, which is below the IN market average of 13.1. The recent drop in earnings per share would almost certainly temper expectations, the relatively strong balance sheet will allow the company time to invest in growth. If it achieves that, then there's real potential that the low P/E could eventually indicate undervaluation.

Investors should be looking to buy stocks that the market is wrong about. 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. Although we don't have analyst forecasts, you could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.

You might be able to find a better buy than Thirumalai Chemicals. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

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.