The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at Varroc Engineering Limited's (NSE:VARROC) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, Varroc Engineering has a P/E ratio of 17.92. That is equivalent to an earnings yield of about 5.6%.
How Do You Calculate Varroc Engineering's P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Varroc Engineering:
P/E of 17.92 = ₹588.85 ÷ ₹32.86 (Based on the year to December 2018.)
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. That isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Growth Rates Impact P/E Ratios
When earnings fall, the 'E' decreases, over time. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.
Varroc Engineering had pretty flat EPS growth in the last year. But EPS is up 52% over the last 5 years. And it has shrunk its earnings per share by 5.1% per year over the last three years. This growth rate might warrant a low P/E ratio. So you wouldn't expect a very high P/E.
How Does Varroc Engineering's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Varroc Engineering has a higher P/E than the average (15.9) P/E for companies in the auto components industry.
That means that the market expects Varroc Engineering 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.
Remember: P/E Ratios Don't Consider The Balance Sheet
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. So it won't reflect the advantage of cash, or disadvantage of debt. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
Varroc Engineering's Balance Sheet
Net debt totals 20% of Varroc Engineering's market cap. It would probably deserve a higher P/E ratio if it was net cash, since it would have more options for growth.
The Verdict On Varroc Engineering's P/E Ratio
Varroc Engineering's P/E is 17.9 which is above average (16.3) in the IN market. With modest debt relative to its size, and modest earnings growth, the market is likely expecting sustained long-term growth, if not a near-term improvement.
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 report on the analyst consensus forecasts could help you make a master move on this stock.
But note: Varroc Engineering 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).
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