The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll show how you can use SoftTech Engineers Limited's (NSE:SOFTTECH) P/E ratio to inform your assessment of the investment opportunity. SoftTech Engineers has a price to earnings ratio of 5.79, based on the last twelve months. That corresponds to an earnings yield of approximately 17%.
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How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for SoftTech Engineers:
P/E of 5.79 = ₹59 ÷ ₹10.18 (Based on the trailing twelve months to September 2018.)
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 Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means unless the share price increases, the P/E will reduce in a few years. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Most would be impressed by SoftTech Engineers earnings growth of 23% in the last year. And its annual EPS growth rate over 5 years is 19%. So one might expect an above average P/E ratio.
Does SoftTech Engineers Have A Relatively High Or Low P/E For Its Industry?
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 SoftTech Engineers has a lower P/E than the average (16.1) P/E for companies in the software industry.
SoftTech Engineers'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.
Remember: P/E Ratios Don't Consider The Balance Sheet
Don't forget that the P/E ratio considers market capitalization. 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).
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.