Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll apply a basic P/E ratio analysis to Sumit Woods Limited's (NSE:SUMIT), to help you decide if the stock is worth further research. Looking at earnings over the last twelve months, Sumit Woods has a P/E ratio of 9. In other words, at today's prices, investors are paying ₹9 for every ₹1 in prior year profit.

Check out our latest analysis for Sumit Woods

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)

Or for Sumit Woods:

P/E of 9 = ₹18.6 ÷ ₹2.07 (Based on the year to June 2019.)

Is A High P/E 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.'

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

We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Sumit Woods has a lower P/E than the average (15.8) P/E for companies in the real estate industry.

Sumit Woods's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Many investors like to buy stocks when the market is pessimistic about their prospects. 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. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

Sumit Woods saw earnings per share decrease by 42% last year. But over the longer term (5 years) earnings per share have increased by 10%.

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. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.

Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

So What Does Sumit Woods's Balance Sheet Tell Us?

Sumit Woods has net debt worth 70% of its market capitalization. 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 Sumit Woods's P/E Ratio

Sumit Woods trades on a P/E ratio of 9, which is below the IN market average of 13.3. The P/E reflects market pessimism that probably arises from the lack of recent EPS growth, paired with significant leverage.

Investors should be looking to buy stocks that the market is wrong about. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. We don't have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.

But note: Sumit Woods may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

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.