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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).

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).

So What Does ITC's Balance Sheet Tell Us?

Since ITC holds net cash of ₹180b, it can spend on growth, justifying a higher P/E ratio than otherwise.

The Verdict On ITC's P/E Ratio

ITC's P/E is 26.6 which is above average (15.5) in the IN market. With cash in the bank the company has plenty of growth options -- and it is already on the right track. Therefore it seems reasonable that the market would have relatively high expectations of the company

Investors have an opportunity when market expectations about a stock are wrong. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

You might be able to find a better buy than ITC. 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.