Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use Hansen Technologies Ltd's (ASX:HSN) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Hansen Technologies's P/E ratio is 25.09. In other words, at today's prices, investors are paying A$25.09 for every A$1 in prior year profit.

Check out our latest analysis for Hansen Technologies

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

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

Or for Hansen Technologies:

P/E of 25.09 = A$3.05 ÷ A$0.12 (Based on the trailing twelve months to December 2018.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that investors are paying a higher price for each A$1 of company 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

Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. 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.

Hansen Technologies's earnings per share fell by 19% in the last twelve months. But EPS is up 9.1% over the last 5 years.

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

The P/E ratio essentially measures market expectations of a company. If you look at the image below, you can see Hansen Technologies has a lower P/E than the average (35.6) in the software industry classification.

Its relatively low P/E ratio indicates that Hansen Technologies shareholders think it will struggle to do as well as other companies in its industry classification. Many investors like to buy stocks when the market is pessimistic about their prospects. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

Remember: P/E Ratios Don't Consider The Balance Sheet

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won't reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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 Hansen Technologies's Balance Sheet Tell Us?

Hansen Technologies has net debt worth just 0.09% of its market capitalization. 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 Hansen Technologies's P/E Ratio

Hansen Technologies trades on a P/E ratio of 25.1, which is above the AU market average of 16.2. With a bit of debt, but a lack of recent growth, it's safe to say the market is expecting improved profit performance from the company, in the next few years.

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.

You might be able to find a better buy than Hansen Technologies. 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.