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.

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.

Is Debt Impacting RedHill Education's P/E?

With net cash of AU$13m, RedHill Education has a very strong balance sheet, which may be important for its business. Having said that, at 21% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Bottom Line On RedHill Education's P/E Ratio

RedHill Education trades on a P/E ratio of 40.8, which is above its market average of 18.7. The recent drop in earnings per share might keep value investors away, 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.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E 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.