Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how Wheels India Limited's (NSE:WHEELS) P/E ratio could help you assess the value on offer. What is Wheels India's P/E ratio? Well, based on the last twelve months it is 21.38. In other words, at today's prices, investors are paying ₹21.38 for every ₹1 in prior year profit.

View our latest analysis for Wheels India

How Do I Calculate Wheels India's Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for Wheels India:

P/E of 21.38 = ₹600.8 ÷ ₹28.1 (Based on the year 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. 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.'

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

One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. You can see in the image below that the average P/E (12.8) for companies in the auto components industry is lower than Wheels India's P/E.

Its relatively high P/E ratio indicates that Wheels India shareholders think it will perform better than other companies in its industry classification. Clearly the market expects growth, but it isn't guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

How Growth Rates Impact P/E Ratios

Probably the most important factor in determining what P/E a company trades on is the earnings growth. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.

Wheels India shrunk earnings per share by 10% over the last year. But over the longer term (5 years) earnings per share have increased by 16%.

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

The 'Price' in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

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).

Wheels India's Balance Sheet

Net debt is 34% of Wheels India's market cap. While that's enough to warrant consideration, it doesn't really concern us.

The Verdict On Wheels India's P/E Ratio

Wheels India has a P/E of 21.4. That's higher than the average in its market, which is 13.3. With modest debt but no EPS growth in the last year, it's fair to say the P/E implies some optimism about future earnings, from the market.

Investors should be looking to buy stocks that the market is wrong about. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.

Of course you might be able to find a better stock than Wheels India. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.