The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at Zhejiang Tengy Environmental Technology Co., Ltd's (HKG:1527) P/E ratio and reflect on what it tells us about the company's share price. Zhejiang Tengy Environmental Technology has a price to earnings ratio of 10.7, based on the last twelve months. In other words, at today's prices, investors are paying HK$10.7 for every HK$1 in prior year profit.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)
Or for Zhejiang Tengy Environmental Technology:
P/E of 10.7 = CN¥2.15 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.20 (Based on the trailing twelve months to June 2019.)
Is A High P/E Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing 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 Zhejiang Tengy Environmental Technology's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Zhejiang Tengy Environmental Technology has a P/E ratio that is roughly in line with the machinery industry average (10.5).
Its P/E ratio suggests that Zhejiang Tengy Environmental Technology shareholders think that in the future it will perform about the same as other companies in its industry classification. The company could surprise by performing better than average, in the future. I would further inform my view by checking insider buying and selling., among other things.
How Growth Rates Impact P/E Ratios
Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means even if the current P/E is low, it will increase over time if the share price stays flat. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
Zhejiang Tengy Environmental Technology saw earnings per share decrease by 68% last year. And EPS is down 4.9% a year, over the last 5 years. This could justify a pessimistic P/E.
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. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
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.
So What Does Zhejiang Tengy Environmental Technology's Balance Sheet Tell Us?
Zhejiang Tengy Environmental Technology has net debt equal to 32% of its market cap. While it's worth keeping this in mind, it isn't a worry.
The Bottom Line On Zhejiang Tengy Environmental Technology's P/E Ratio
Zhejiang Tengy Environmental Technology trades on a P/E ratio of 10.7, which is fairly close to the HK market average of 10.7. When you consider the lack of EPS growth last year (along with some debt), it seems the market is optimistic about the future for the business.
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 you might want to assess this data-rich visualization of earnings, revenue and cash flow.
You might be able to find a better buy than Zhejiang Tengy Environmental Technology. 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).
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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.