Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!
Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at AEON Credit Service (Asia) Company Limited's (HKG:900) P/E ratio and reflect on what it tells us about the company's share price. Based on the last twelve months, AEON Credit Service (Asia)'s P/E ratio is 7.02. In other words, at today's prices, investors are paying HK$7.02 for every HK$1 in prior year profit.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for AEON Credit Service (Asia):
P/E of 7.02 = HK$7.12 ÷ HK$1.01 (Based on the year to May 2019.)
Is A High Price-to-Earnings Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing 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.'
Does AEON Credit Service (Asia) 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. The image below shows that AEON Credit Service (Asia) has a lower P/E than the average (7.6) P/E for companies in the consumer finance industry.
AEON Credit Service (Asia)'s P/E tells us that market participants think it will not fare as well as its peers in the same 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.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. When earnings grow, the 'E' increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
AEON Credit Service (Asia) saw earnings per share improve by -6.6% last year.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. 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).
How Does AEON Credit Service (Asia)'s Debt Impact Its P/E Ratio?
Net debt totals 64% of AEON Credit Service (Asia)'s market cap. This is enough debt that you'd have to make some adjustments before using the P/E ratio to compare it to a company with net cash.
The Verdict On AEON Credit Service (Asia)'s P/E Ratio
AEON Credit Service (Asia) trades on a P/E ratio of 7, which is below the HK market average of 10.7. The meaningful debt load is probably contributing to low expectations, even though it has improved earnings recently.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. We don't have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.
Of course you might be able to find a better stock than AEON Credit Service (Asia). 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.