Why Dr. Lal PathLabs Limited's (NSE:LALPATHLAB) High P/E Ratio Isn't Necessarily A Bad Thing

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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how Dr. Lal PathLabs Limited's (NSE:LALPATHLAB) P/E ratio could help you assess the value on offer. Dr. Lal PathLabs has a P/E ratio of 41.83, based on the last twelve months. That is equivalent to an earnings yield of about 2.4%.

See our latest analysis for Dr. Lal PathLabs

How Do I Calculate Dr. Lal PathLabs's Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for Dr. Lal PathLabs:

P/E of 41.83 = ₹977.2 ÷ ₹23.36 (Based on the year to December 2018.)

Is A High Price-to-Earnings Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

Most would be impressed by Dr. Lal PathLabs earnings growth of 20% in the last year. And earnings per share have improved by 10% annually, over the last five years. So one might expect an above average P/E ratio.

How Does Dr. Lal PathLabs's P/E Ratio Compare To Its Peers?

The P/E ratio indicates whether the market has higher or lower expectations of a company. You can see in the image below that the average P/E (22.5) for companies in the healthcare industry is lower than Dr. Lal PathLabs's P/E.

That means that the market expects Dr. Lal PathLabs will outperform other companies in its industry. The market is optimistic about the future, but that doesn't guarantee future growth. 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

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. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).

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).

Dr. Lal PathLabs's Balance Sheet

Dr. Lal PathLabs has net cash of ₹6.5b. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.

The Verdict On Dr. Lal PathLabs's P/E Ratio

Dr. Lal PathLabs trades on a P/E ratio of 41.8, which is above the IN market average of 15.4. Its net cash position supports a higher P/E ratio, as does its solid recent earnings growth. So it does not seem strange that the P/E is above average.

Investors should be looking to buy stocks that the market is wrong about. 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.

You might be able to find a better buy than Dr. Lal PathLabs. 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.