Should You Be Tempted To Sell Dr. Reddy’s Laboratories Limited (NSE:DRREDDY) Because Of Its P/E Ratio?

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This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Dr. Reddy’s Laboratories Limited’s (NSE:DRREDDY) P/E ratio could help you assess the value on offer. Dr. Reddy’s Laboratories has a price to earnings ratio of 22.59, based on the last twelve months. In other words, at today’s prices, investors are paying ₹22.59 for every ₹1 in prior year profit.

Check out our latest analysis for Dr. Reddy’s Laboratories

How Do You Calculate Dr. Reddy’s Laboratories’s P/E Ratio?

The formula for price to earnings is:

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

Or for Dr. Reddy’s Laboratories:

P/E of 22.59 = ₹2655.5 ÷ ₹117.53 (Based on the trailing twelve months to March 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.’

How Does Dr. Reddy’s Laboratories’s P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. As you can see below, Dr. Reddy’s Laboratories has a higher P/E than the average company (16.6) in the pharmaceuticals industry.

NSEI:DRREDDY Price Estimation Relative to Market, July 21st 2019
NSEI:DRREDDY Price Estimation Relative to Market, July 21st 2019

Dr. Reddy’s Laboratories’s P/E tells us that market participants think the company will perform better than its industry peers, going forward.

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. If earnings are growing quickly, then the ‘E’ in the equation will increase faster than it would otherwise. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Dr. Reddy’s Laboratories’s 106% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. Unfortunately, earnings per share are down 1.5% a year, over 5 years.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

Don’t forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

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.

Dr. Reddy’s Laboratories’s Balance Sheet

Dr. Reddy’s Laboratories’s net debt is 2.7% of its market cap. The market might award it a higher P/E ratio if it had net cash, but its unlikely this low level of net borrowing is having a big impact on the P/E multiple.

The Bottom Line On Dr. Reddy’s Laboratories’s P/E Ratio

Dr. Reddy’s Laboratories’s P/E is 22.6 which is above average (14.5) in its market. While the company does use modest debt, its recent earnings growth is superb. So on this analysis a high P/E ratio seems reasonable.

When the market is wrong about a stock, it gives savvy investors an opportunity. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.

You might be able to find a better buy than Dr. Reddy’s Laboratories. 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.