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Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how Ajanta Pharma Limited's (NSE:AJANTPHARM) P/E ratio could help you assess the value on offer. What is Ajanta Pharma's P/E ratio? Well, based on the last twelve months it is 22.78. That is equivalent to an earnings yield of about 4.4%.

See our latest analysis for Ajanta Pharma

How Do You Calculate Ajanta Pharma's P/E Ratio?

The formula for price to earnings is:

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

Or for Ajanta Pharma:

P/E of 22.78 = ₹1001.65 ÷ ₹43.97 (Based on the trailing twelve months to March 2019.)

Is A High P/E Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each ₹1 the company has earned over the last year. 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

When earnings fall, the 'E' decreases, over time. That means even if the current P/E is low, it will increase over time if the share price stays flat. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.

Ajanta Pharma's earnings per share fell by 17% in the last twelve months. But it has grown its earnings per share by 11% per year over the last five years. And it has shrunk its earnings per share by 2.4% per year over the last three years. This could justify a low P/E.

How Does Ajanta Pharma's P/E Ratio Compare To Its Peers?

The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Ajanta Pharma has a higher P/E than the average (18.8) P/E for companies in the pharmaceuticals industry.

That means that the market expects Ajanta Pharma will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

Remember: P/E Ratios Don't Consider The Balance Sheet

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. Thus, the metric does not reflect cash or debt held by the company. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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.

Ajanta Pharma's Balance Sheet

Since Ajanta Pharma holds net cash of ₹1.3b, it can spend on growth, justifying a higher P/E ratio than otherwise.

The Verdict On Ajanta Pharma's P/E Ratio

Ajanta Pharma trades on a P/E ratio of 22.8, which is above the IN market average of 16.1. The recent drop in earnings per share would make some investors cautious, but the healthy balance sheet means the company retains potential for future growth. If fails to eventuate, the current high P/E could prove to be temporary, as the share price falls.

Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. 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 Ajanta Pharma. 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.