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 Tata Elxsi Limited’s (NSE:TATAELXSI) P/E ratio could help you assess the value on offer. Based on the last twelve months, Tata Elxsi’s P/E ratio is 21.61. That is equivalent to an earnings yield of about 4.6%.
See our latest analysis for Tata Elxsi
How Do You Calculate Tata Elxsi’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 Elxsi:
P/E of 21.61 = ₹991.4 ÷ ₹45.88 (Based on the trailing twelve months to September 2018.)
Is A High P/E 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. 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 Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. When earnings grow, the ‘E’ increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
Tata Elxsi increased earnings per share by a whopping 48% last year. And earnings per share have improved by 28% annually, over the last five years. With that performance, I would expect it to have an above average P/E ratio.
How Does Tata Elxsi’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Tata Elxsi has a higher P/E than the average (16.6) P/E for companies in the software industry.
That means that the market expects Tata Elxsi 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
The ‘Price’ in P/E reflects the market capitalization of the company. That means it doesn’t take debt or cash into account. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
Tata Elxsi’s Balance Sheet
Since Tata Elxsi holds net cash of ₹4.8b, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Tata Elxsi’s P/E Ratio
Tata Elxsi has a P/E of 21.6. That’s higher than the average in the IN market, which is 17.1. Its strong balance sheet gives the company plenty of resources for extra growth, and it has already proven it can grow. So it is not surprising the market is probably extrapolating recent growth well into the future, reflected in the relatively high P/E ratio.
When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. 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.
But note: Tata Elxsi may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.