The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how QAF Limited's (SGX:Q01) P/E ratio could help you assess the value on offer. Based on the last twelve months, QAF's P/E ratio is 53.86. That is equivalent to an earnings yield of about 1.9%.

Check out our latest analysis for QAF

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for QAF:

P/E of 53.86 = SGD0.86 ÷ SGD0.02 (Based on the trailing twelve months to September 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that investors are paying a higher price for each SGD1 of company earnings. 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 QAF's P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. The image below shows that QAF has a significantly higher P/E than the average (14.9) P/E for companies in the food industry.

Its relatively high P/E ratio indicates that QAF shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn't guarantee future growth. So further research is always essential. I often monitor director buying and selling.

How Growth Rates Impact P/E Ratios

When earnings fall, the 'E' decreases, over time. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. Then, a higher P/E might scare off shareholders, pushing the share price down.

It's nice to see that QAF grew EPS by a stonking 46% in the last year. Unfortunately, earnings per share are down 27% a year, over 5 years.

Don't Forget: The P/E Does Not Account For Debt or Bank Deposits

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. That means it doesn't take debt or cash into account. 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.

How Does QAF's Debt Impact Its P/E Ratio?

QAF's net debt is 13% of its market cap. That's enough debt to impact the P/E ratio a little; so keep it in mind if you're comparing it to companies without debt.

The Bottom Line On QAF's P/E Ratio

With a P/E ratio of 53.9, QAF is expected to grow earnings very strongly in the years to come. The company is not overly constrained by its modest debt levels, and its recent EPS growth is nothing short of stand-out. So to be frank we are not surprised it has a high P/E ratio.

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. Although we don't have analyst forecasts you could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.

You might be able to find a better buy than QAF. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

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.

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. Thank you for reading.