Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at Tata Steel Limited's (NSE:TATASTEEL) P/E ratio and reflect on what it tells us about the company's share price. Tata Steel has a P/E ratio of 7.50, based on the last twelve months. That is equivalent to an earnings yield of about 13.3%.
See our latest analysis for Tata Steel
How Do You Calculate Tata Steel's P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Tata Steel:
P/E of 7.50 = ₹387.600 ÷ ₹51.699 (Based on the trailing twelve months to December 2019.)
(Note: the above calculation results may not be precise due to rounding.)
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 Tata Steel 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. The image below shows that Tata Steel has a lower P/E than the average (9.2) P/E for companies in the metals and mining industry.
Its relatively low P/E ratio indicates that Tata Steel shareholders think it will struggle to do as well as other companies in its industry classification. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. 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. Then, a lower P/E should attract more buyers, pushing the share price up.
Tata Steel saw earnings per share decrease by 67% last year. But over the longer term (5 years) earnings per share have increased by 14%.
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. Thus, the metric does not reflect cash or debt held by the company. 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).
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.
So What Does Tata Steel's Balance Sheet Tell Us?
Tata Steel's net debt is considerable, at 227% of its market cap. If you want to compare its P/E ratio to other companies, you must keep in mind that these debt levels would usually warrant a relatively low P/E.
The Bottom Line On Tata Steel's P/E Ratio
Tata Steel has a P/E of 7.5. That's below the average in the IN market, which is 12.5. Given meaningful debt, and a lack of recent growth, the market looks to be extrapolating this recent performance; reflecting low expectations for the future.
When the market is wrong about a stock, it gives savvy investors an opportunity. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
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.
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.
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