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 Kotak Mahindra Bank Limited's (NSE:KOTAKBANK) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, Kotak Mahindra Bank has a P/E ratio of 37.27. In other words, at today's prices, investors are paying ₹37.27 for every ₹1 in prior year profit.
How Do You Calculate Kotak Mahindra Bank's P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Kotak Mahindra Bank:
P/E of 37.27 = ₹1605.45 ÷ ₹43.08 (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 ₹1 of company 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 Kotak Mahindra Bank'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 Kotak Mahindra Bank has a higher P/E than the average (20.4) P/E for companies in the banks industry.
That means that the market expects Kotak Mahindra Bank will outperform other companies in its industry. The market is optimistic about the future, but that doesn't guarantee future growth. 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
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. And in that case, the P/E ratio itself will drop rather quickly. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
It's great to see that Kotak Mahindra Bank grew EPS by 22% in the last year. And it has bolstered its earnings per share by 20% per year over the last five years. This could arguably justify a relatively high P/E ratio.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
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.
Kotak Mahindra Bank's Balance Sheet
Kotak Mahindra Bank has net debt worth 14% of its market capitalization. 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 Verdict On Kotak Mahindra Bank's P/E Ratio
Kotak Mahindra Bank trades on a P/E ratio of 37.3, which is above its market average of 13.2. While the company does use modest debt, its recent earnings growth is very good. Therefore, it's not particularly surprising that it has a above average P/E ratio.
When the market is wrong about a stock, it gives savvy investors an opportunity. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
Of course you might be able to find a better stock than Kotak Mahindra Bank. 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 email@example.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.