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 Lycopodium Limited's (ASX:LYL), to help you decide if the stock is worth further research. Based on the last twelve months, Lycopodium's P/E ratio is 13.33. That means that at current prices, buyers pay A$13.33 for every A$1 in trailing yearly profits.

View our latest analysis for Lycopodium

How Do I Calculate A Price To Earnings Ratio?

The formula for P/E is:

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

Or for Lycopodium:

P/E of 13.33 = A$5.54 ÷ A$0.42 (Based on the year to June 2019.)

Is A High P/E Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each A$1 the company has earned over the last year. 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 Lycopodium's P/E Ratio Compare To Its Peers?

The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Lycopodium has a P/E ratio that is roughly in line with the construction industry average (13.8).

That indicates that the market expects Lycopodium will perform roughly in line with other companies in its industry. If the company has better than average prospects, then the market might be underestimating it. I would further inform my view by checking insider buying and selling., among other things.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. Earnings growth means that in the future the 'E' will be higher. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.

Lycopodium saw earnings per share decrease by 11% last year. But over the longer term (5 years) earnings per share have increased by 33%.

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.

While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.

Is Debt Impacting Lycopodium's P/E?

With net cash of AU$60m, Lycopodium has a very strong balance sheet, which may be important for its business. Having said that, at 28% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Bottom Line On Lycopodium's P/E Ratio

Lycopodium's P/E is 13.3 which is below average (18.2) in the AU market. Falling earnings per share are likely to be keeping potential buyers away, the healthy balance sheet means the company retains potential for future growth. If that occurs, the current low P/E could prove to be temporary.

Investors should be looking to buy stocks that the market is wrong about. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.

But note: Lycopodium 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).

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.