The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We’ll show how you can use Changmao Biochemical Engineering Company Limited’s (HKG:954) P/E ratio to inform your assessment of the investment opportunity. Changmao Biochemical Engineering has a price to earnings ratio of 20.09, based on the last twelve months. That corresponds to an earnings yield of approximately 5.0%.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for Changmao Biochemical Engineering:
P/E of 20.09 = CN¥0.64 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.032 (Based on the year to June 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. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
How Growth Rates Impact P/E Ratios
When earnings fall, the ‘E’ decreases, over time. That means unless the share price falls, the P/E will increase in a few years. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
Notably, Changmao Biochemical Engineering grew EPS by a whopping 30% in the last year. But earnings per share are down 29% per year over the last five years.
How Does Changmao Biochemical Engineering’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 (8.7) for companies in the chemicals industry is lower than Changmao Biochemical Engineering’s P/E.
That means that the market expects Changmao Biochemical Engineering will outperform other companies in its industry. Clearly the market expects growth, but it isn’t guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
Remember: P/E Ratios Don’t Consider The Balance Sheet
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. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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 Changmao Biochemical Engineering’s Debt Impact Its P/E Ratio?
The extra options and safety that comes with Changmao Biochemical Engineering’s CN¥38m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Verdict On Changmao Biochemical Engineering’s P/E Ratio
Changmao Biochemical Engineering’s P/E is 20.1 which is above average (10.3) in the HK market. With cash in the bank the company has plenty of growth options — and it is already on the right track. So it does not seem strange that the P/E is above average.
Investors should be looking to buy stocks that the market is wrong about. 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.’ We don’t have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than Changmao Biochemical Engineering. 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).
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.