Why Larsen & Toubro Limited’s (NSE:LT) High P/E Ratio Isn’t Necessarily A Bad Thing

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This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We’ll look at Larsen & Toubro Limited’s (NSE:LT) P/E ratio and reflect on what it tells us about the company’s share price. Based on the last twelve months, Larsen & Toubro’s P/E ratio is 23.89. That is equivalent to an earnings yield of about 4.2%.

See our latest analysis for Larsen & Toubro

How Do I Calculate Larsen & Toubro’s Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for Larsen & Toubro:

P/E of 23.89 = ₹1516.95 ÷ ₹63.51 (Based on the trailing twelve months to March 2019.)

Is A High Price-to-Earnings 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

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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Larsen & Toubro increased earnings per share by an impressive 21% over the last twelve months. And it has bolstered its earnings per share by 12% per year over the last five years. So one might expect an above average P/E ratio.

How Does Larsen & Toubro’s P/E Ratio Compare To Its Peers?

One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. The image below shows that Larsen & Toubro has a higher P/E than the average (14.9) P/E for companies in the construction industry.

NSEI:LT Price Estimation Relative to Market, June 15th 2019
NSEI:LT Price Estimation Relative to Market, June 15th 2019

Its relatively high P/E ratio indicates that Larsen & Toubro shareholders think it will perform better than other companies in its industry classification. Clearly the market expects growth, but it isn’t guaranteed. So further research is always essential. I often monitor director buying and selling.

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. 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.

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).

How Does Larsen & Toubro’s Debt Impact Its P/E Ratio?

Larsen & Toubro has net debt equal to 46% of its market cap. While that’s enough to warrant consideration, it doesn’t really concern us.

The Verdict On Larsen & Toubro’s P/E Ratio

Larsen & Toubro has a P/E of 23.9. That’s higher than the average in the IN market, which is 15.9. While the company does use modest debt, its recent earnings growth is very good. So on this analysis it seems reasonable that its P/E ratio is above average.

Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, ‘In the short run, the market is a voting machine but in the long run, it is a weighing machine.’ 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 Larsen & Toubro. 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.