This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll show how you can use RedHill Education Limited's (ASX:RDH) P/E ratio to inform your assessment of the investment opportunity. Looking at earnings over the last twelve months, RedHill Education has a P/E ratio of 40.78. That means that at current prices, buyers pay A$40.78 for every A$1 in trailing yearly profits.

See our latest analysis for RedHill Education

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for RedHill Education:

P/E of 40.78 = A$2.00 ÷ A$0.05 (Based on the year to June 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. 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.

Does RedHill Education 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. You can see in the image below that the average P/E (19.1) for companies in the consumer services industry is lower than RedHill Education's P/E.

RedHill Education's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Shareholders are clearly optimistic, but the future is always uncertain. So investors should delve deeper. I like to check if company insiders have been buying or selling.

How Growth Rates Impact P/E Ratios

Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means unless the share price increases, the P/E will reduce in a few years. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

RedHill Education shrunk earnings per share by 57% over the last year. But EPS is up 65% over the last 3 years. And EPS is down 21% a year, over the last 5 years. This could justify a pessimistic P/E.

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. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.