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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 ITC Limited's (NSE:ITC) P/E ratio to inform your assessment of the investment opportunity. What is ITC's P/E ratio? Well, based on the last twelve months it is 26.64. That corresponds to an earnings yield of approximately 3.8%.
Check out our latest analysis for ITC
How Do I Calculate ITC's Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for ITC:
P/E of 26.64 = ₹274.25 ÷ ₹10.3 (Based on the trailing twelve months 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. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.'
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. When earnings grow, the 'E' increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
ITC increased earnings per share by an impressive 11% over the last twelve months. And earnings per share have improved by 6.6% annually, over the last five years. So one might expect an above average P/E ratio.
Does ITC 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. As you can see below, ITC has a higher P/E than the average company (17.8) in the tobacco industry.
Its relatively high P/E ratio indicates that ITC shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
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. That means it doesn't take debt or cash into account. 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).