Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll apply a basic P/E ratio analysis to Indra Sistemas, S.A.'s (BME:IDR), to help you decide if the stock is worth further research. Indra Sistemas has a P/E ratio of 10.26, based on the last twelve months. That corresponds to an earnings yield of approximately 9.7%.

View our latest analysis for Indra Sistemas

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 Indra Sistemas:

P/E of 10.26 = €6.8 ÷ €0.66 (Based on the year to June 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 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.

How Does Indra Sistemas's P/E Ratio Compare To Its Peers?

One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. The image below shows that Indra Sistemas has a lower P/E than the average (19.9) P/E for companies in the it industry.

Its relatively low P/E ratio indicates that Indra Sistemas shareholders think it will struggle to do as well as other companies in its industry classification. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or selling.

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. 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.

Indra Sistemas's earnings per share fell by 7.2% in the last twelve months. And over the longer term (5 years) earnings per share have decreased 3.3% annually. So it would be surprising to see a high P/E.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

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 expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

So What Does Indra Sistemas's Balance Sheet Tell Us?

Indra Sistemas's net debt is 60% of its market cap. This is a reasonably significant level of debt -- all else being equal you'd expect a much lower P/E than if it had net cash.

The Verdict On Indra Sistemas's P/E Ratio

Indra Sistemas trades on a P/E ratio of 10.3, which is below the ES market average of 17.1. Given meaningful debt, and a lack of recent growth, the market looks to be extrapolating this recent performance; reflecting low expectations for the future.

Investors should be looking to buy stocks that the market is wrong about. 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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

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.