This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Rama Steel Tubes Limited’s (NSE:RAMASTEEL) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, Rama Steel Tubes has a P/E ratio of 19.81. That is equivalent to an earnings yield of about 5.0%.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Rama Steel Tubes:
P/E of 19.81 = INR44.00 ÷ INR2.22 (Based on the trailing twelve months to December 2019.)
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. All else being equal, it’s better to pay a low price — but as Warren Buffett said, ‘It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price’.
Does Rama Steel Tubes Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio indicates whether the market has higher or lower expectations of a company. As you can see below, Rama Steel Tubes has a higher P/E than the average company (10.2) in the metals and mining industry.
That means that the market expects Rama Steel Tubes will outperform other companies in its industry. 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
Companies that shrink earnings per share quickly will rapidly decrease the ‘E’ in the equation. That means unless the share price falls, the P/E will increase in a few years. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
Rama Steel Tubes saw earnings per share decrease by 65% last year. But EPS is up 37% over the last 5 years. And EPS is down 29% a year, over the last 3 years. This growth rate might warrant a low P/E ratio.
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. 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 expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
Is Debt Impacting Rama Steel Tubes’s P/E?
Net debt totals 96% of Rama Steel Tubes’s market cap. This is enough debt that you’d have to make some adjustments before using the P/E ratio to compare it to a company with net cash.
The Verdict On Rama Steel Tubes’s P/E Ratio
Rama Steel Tubes has a P/E of 19.8. That’s higher than the average in its market, which is 13.3. With significant debt and no EPS growth last year, shareholders are betting on an improvement in earnings from the company.
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. Although we don’t have analyst forecasts shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
Of course you might be able to find a better stock than Rama Steel Tubes. So you may wish to see this free collection of other companies that have grown earnings strongly.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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