This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Larsen & Toubro Limited's (NSE:LT), to help you decide if the stock is worth further research. Larsen & Toubro has a P/E ratio of 20.39, based on the last twelve months. In other words, at today's prices, investors are paying ₹20.39 for every ₹1 in prior year profit.
How Do I Calculate Larsen & Toubro's Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Larsen & Toubro:
P/E of 20.39 = ₹1328.1 ÷ ₹65.15 (Based on the year to June 2019.)
Is A High P/E 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 Larsen & Toubro's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (12.8) for companies in the construction industry is lower than Larsen & Toubro's P/E.
Larsen & Toubro's P/E tells us that market participants think the company will perform better than its industry peers, going forward. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the 'E' will be higher. 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.
Most would be impressed by Larsen & Toubro earnings growth of 19% in the last year. And its annual EPS growth rate over 5 years is 11%. This could arguably justify a relatively high P/E ratio.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn't take debt or cash into account. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
Larsen & Toubro's Balance Sheet
Net debt totals 55% of Larsen & Toubro's market cap. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.
The Verdict On Larsen & Toubro's P/E Ratio
Larsen & Toubro trades on a P/E ratio of 20.4, which is above its market average of 13.1. While the meaningful level of debt does limit its options, it has achieved solid growth over the last year. But if growth falters, the relatively high P/E ratio may prove to be unjustified.
Investors have an opportunity when market expectations about a stock are wrong. 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 be able to find a better stock than Larsen & Toubro. 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.