This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at Avarga Limited's (SGX:U09) P/E ratio and reflect on what it tells us about the company's share price. Based on the last twelve months, Avarga's P/E ratio is 5.92. That means that at current prices, buyers pay SGD5.92 for every SGD1 in trailing yearly profits.

View our latest analysis for Avarga

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 Avarga:

P/E of 5.92 = SGD0.17 ÷ SGD0.03 (Based on the trailing twelve months to September 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that investors are paying a higher price for each SGD1 of company earnings. 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.

Does Avarga Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio indicates whether the market has higher or lower expectations of a company. If you look at the image below, you can see Avarga has a lower P/E than the average (13.2) in the forestry industry classification.

Its relatively low P/E ratio indicates that Avarga shareholders think it will struggle to do as well as other companies in its industry classification. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or selling.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. Earnings growth means that in the future the 'E' will be higher. That means even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Avarga's earnings made like a rocket, taking off 65% last year. The cherry on top is that the five year growth rate was an impressive 32% per year. So I'd be surprised if the P/E ratio was not above average.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

Don't forget that the P/E ratio considers market capitalization. That means it doesn't take debt or cash into account. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

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.

So What Does Avarga's Balance Sheet Tell Us?

Avarga's net debt is 72% of its market cap. This is enough debt that you'd have to make some adjustments before using the P/E ratio to compare it to a company with net cash.

The Bottom Line On Avarga's P/E Ratio

Avarga trades on a P/E ratio of 5.9, which is below the SG market average of 13.2. While the EPS growth last year was strong, the significant debt levels reduce the number of options available to management. The low P/E ratio suggests current market expectations are muted, implying these levels of growth will not continue.

When the market is wrong about a stock, it gives savvy investors an opportunity. 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 Avarga. 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).

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.

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. Thank you for reading.