Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!

This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Alembic Limited's (NSE:ALEMBICLTD), to help you decide if the stock is worth further research. Alembic has a P/E ratio of 4.73, based on the last twelve months. That means that at current prices, buyers pay ₹4.73 for every ₹1 in trailing yearly profits.

Check out our latest analysis for Alembic

How Do You Calculate Alembic's P/E Ratio?

The formula for P/E is:

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

Or for Alembic:

P/E of 4.73 = ₹42.2 ÷ ₹8.93 (Based on the trailing twelve months to March 2019.)

Is A High P/E Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.

How Growth Rates Impact P/E Ratios

Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. When earnings grow, the 'E' increases, over time. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.

It's nice to see that Alembic grew EPS by a stonking 46% in the last year. And it has bolstered its earnings per share by 52% per year over the last five years. So we'd generally expect it to have a relatively high P/E ratio.

Does Alembic Have A Relatively High Or Low P/E For Its Industry?

One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. If you look at the image below, you can see Alembic has a lower P/E than the average (17.7) in the pharmaceuticals industry classification.

Alembic's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Many investors like to buy stocks when the market is pessimistic about their prospects. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.

Don't Forget: The P/E Does Not Account For Debt or Bank Deposits

Don't forget that the P/E ratio considers market capitalization. That means it doesn't take debt or cash into account. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.

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 Alembic's Balance Sheet Tell Us?

Alembic has net cash of ₹455m. 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 Alembic's P/E Ratio

Alembic's P/E is 4.7 which is below average (15.4) in the IN market. Not only should the net cash position reduce risk, but the recent growth has been impressive. The below average P/E ratio suggests that market participants don't believe the strong growth will continue.

Investors have an opportunity when market expectations about a stock are wrong. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. We don't have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.

But note: Alembic 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).

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.