This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at Hindcon Chemicals Limited's (NSE:HINDCON) P/E ratio and reflect on what it tells us about the company's share price. Based on the last twelve months, Hindcon Chemicals's P/E ratio is 4.8. That is equivalent to an earnings yield of about 21%.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Hindcon Chemicals:
P/E of 4.8 = ₹17.65 ÷ ₹3.68 (Based on the trailing twelve months to March 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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 Hindcon Chemicals's P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. We can see in the image below that the average P/E (12.1) for companies in the chemicals industry is higher than Hindcon Chemicals's P/E.
This suggests that market participants think Hindcon Chemicals will underperform other companies in its industry. Since the market seems unimpressed with Hindcon Chemicals, it's quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. 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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Hindcon Chemicals saw earnings per share decrease by 19% last year. But it has grown its earnings per share by 33% per year over the last five years.
Remember: P/E Ratios Don't Consider The Balance Sheet
The 'Price' in P/E reflects the market capitalization of the company. 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.
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).
Is Debt Impacting Hindcon Chemicals's P/E?
Hindcon Chemicals has net cash of ₹11m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Bottom Line On Hindcon Chemicals's P/E Ratio
Hindcon Chemicals trades on a P/E ratio of 4.8, which is below the IN market average of 14.5. The recent drop in earnings per share would almost certainly temper expectations, but the net cash position means the company has time to improve: if so, the low P/E could be an opportunity.
Investors have an opportunity when market expectations about a stock are wrong. 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.' We don't have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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If you spot an error that warrants correction, please contact the editor at email@example.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.