This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we’ll show how ELGI Equipments Limited’s (NSE:ELGIEQUIP) P/E ratio could help you assess the value on offer. Based on the last twelve months, ELGI Equipments’s P/E ratio is 40.97. In other words, at today’s prices, investors are paying ₹40.97 for every ₹1 in prior year profit.

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How Do I Calculate ELGI Equipments’s Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for ELGI Equipments:

P/E of 40.97 = ₹256.8 ÷ ₹6.27 (Based on the year to September 2018.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that investors are paying a higher price for each ₹1 of company earnings. That isn’t necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.

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. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.

Notably, ELGI Equipments grew EPS by a whopping 35% in the last year. And earnings per share have improved by 17% annually, over the last five years. So we’d generally expect it to have a relatively high P/E ratio.

How Does ELGI Equipments’s P/E Ratio Compare To Its Peers?

The P/E ratio indicates whether the market has higher or lower expectations of a company. As you can see below, ELGI Equipments has a higher P/E than the average company (19.5) in the machinery industry.

That means that the market expects ELGI Equipments will outperform other companies in its industry. Clearly the market expects growth, but it isn’t guaranteed. So further research is always essential. I often monitor director buying and selling.

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

Don’t forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

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).

ELGI Equipments’s Balance Sheet

ELGI Equipments has net debt worth just 4.4% of its market capitalization. It would probably trade on a higher P/E ratio if it had a lot of cash, but I doubt it is having a big impact.

The Verdict On ELGI Equipments’s P/E Ratio

ELGI Equipments trades on a P/E ratio of 41, which is above the IN market average of 17.1. The company is not overly constrained by its modest debt levels, and it is growing earnings per share. So it is not surprising the market is probably extrapolating recent growth well into the future, reflected in the relatively high P/E ratio.

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 report on the analyst consensus forecasts could help you make a master move on this stock.

Of course you might be able to find a better stock than ELGI Equipments. So you may wish to see this free collection of other companies that have grown earnings strongly.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.