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Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use Xplus S.A.'s (WSE:XPL) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Xplus's P/E ratio is 8.97. In other words, at today's prices, investors are paying PLN8.97 for every PLN1 in prior year profit.

Check out our latest analysis for Xplus

How Do You Calculate A P/E Ratio?

The formula for P/E is:

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

Or for Xplus:

P/E of 8.97 = PLN0.34 ÷ PLN0.038 (Based on the trailing twelve months to December 2018.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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 Growth Rates Impact P/E Ratios

Probably the most important factor in determining what P/E a company trades on is the earnings growth. When earnings grow, the 'E' increases, over time. And in that case, the P/E ratio itself will drop rather quickly. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

Xplus increased earnings per share by a whopping 46% last year. And earnings per share have improved by 12% annually, over the last five years. So we'd generally expect it to have a relatively high P/E ratio.

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

We can get an indication of market expectations by looking at the P/E ratio. We can see in the image below that the average P/E (13.1) for companies in the software industry is higher than Xplus's P/E.

This suggests that market participants think Xplus will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

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. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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.