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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we’ll show how China Everbright Limited’s (HKG:165) P/E ratio could help you assess the value on offer. Based on the last twelve months, China Everbright’s P/E ratio is 5.81. In other words, at today’s prices, investors are paying HK$5.81 for every HK$1 in prior year profit.
How Do You Calculate China Everbright’s P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for China Everbright:
P/E of 5.81 = HK$15.16 ÷ HK$2.61 (Based on the trailing twelve months to June 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each HK$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 Growth Rates Impact P/E Ratios
When earnings fall, the ‘E’ decreases, over time. That means even if the current P/E is low, it will increase over time if the share price stays flat. A higher P/E should indicate the stock is expensive relative to others — and that may encourage shareholders to sell.
China Everbright’s earnings per share grew by -5.7% in the last twelve months. And its annual EPS growth rate over 5 years is 20%. In contrast, EPS has decreased by 3.8%, annually, over 3 years.
How Does China Everbright’s P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. If you look at the image below, you can see China Everbright has a lower P/E than the average (13.2) in the capital markets industry classification.
Its relatively low P/E ratio indicates that China Everbright shareholders think it will struggle to do as well as other companies in its industry classification. 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.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
The ‘Price’ in P/E reflects the market capitalization of the company. 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.
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.
Is Debt Impacting China Everbright’s P/E?
China Everbright’s net debt is 84% of its 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 Bottom Line On China Everbright’s P/E Ratio
China Everbright trades on a P/E ratio of 5.8, which is below the HK market average of 10.5. 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 it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. 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.
You might be able to find a better buy than China Everbright. 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).
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. On rare occasion, data errors may occur. Thank you for reading.