The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll show how you can use Leonardo S.p.a.'s (BIT:LDO) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Leonardo's P/E ratio is 10.61. That is equivalent to an earnings yield of about 9.4%.

View our latest analysis for Leonardo

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

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

Or for Leonardo:

P/E of 10.61 = €10.45 ÷ €0.98 (Based on the trailing twelve months to June 2019.)

Is A High Price-to-Earnings 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. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.

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

We can get an indication of market expectations by looking at the P/E ratio. We can see in the image below that the average P/E (21.4) for companies in the aerospace & defense industry is higher than Leonardo's P/E.

This suggests that market participants think Leonardo will underperform other companies in its industry. Since the market seems unimpressed with Leonardo, 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

P/E ratios primarily reflect market expectations around earnings growth rates. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means unless the share price increases, the P/E will reduce in a few years. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Leonardo's earnings made like a rocket, taking off 233% last year. And earnings per share have improved by 15% annually, over the last three years. So we'd absolutely expect it to have a relatively high P/E ratio.

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

Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. 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.

Leonardo's Balance Sheet

Net debt totals 71% of Leonardo's market cap. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.

The Verdict On Leonardo's P/E Ratio

Leonardo trades on a P/E ratio of 10.6, which is below the IT market average of 16.8. The company may have significant debt, but EPS growth was good last year. If it continues to grow, then the current low P/E may prove to be unjustified.

Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

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.

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.