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Despite Its High P/E Ratio, Is China Tobacco International (HK) Company Limited (HKG:6055) Still Undervalued?

Simply Wall St

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 China Tobacco International (HK) Company Limited's (HKG:6055) P/E ratio to inform your assessment of the investment opportunity. China Tobacco International (HK) has a price to earnings ratio of 33.58, based on the last twelve months. That is equivalent to an earnings yield of about 3.0%.

Check out our latest analysis for China Tobacco International (HK)

How Do I Calculate China Tobacco International (HK)'s Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for China Tobacco International (HK):

P/E of 33.58 = HKD17.70 ÷ HKD0.53 (Based on the trailing twelve months to December 2019.)

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.

Does China Tobacco International (HK) 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. The image below shows that China Tobacco International (HK) has a significantly higher P/E than the average (11.1) P/E for companies in the retail distributors industry.

SEHK:6055 Price Estimation Relative to Market, February 17th 2020

Its relatively high P/E ratio indicates that China Tobacco International (HK) shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should delve deeper. I like to check if company insiders have been buying or selling.

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. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. And in that case, the P/E ratio itself will drop rather quickly. Then, a lower P/E should attract more buyers, pushing the share price up.

China Tobacco International (HK) maintained roughly steady earnings over the last twelve months.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

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 China Tobacco International (HK)'s Debt Impact Its P/E Ratio?

China Tobacco International (HK) has net cash of HK$1.8b. This is fairly high at 15% of its market capitalization. That might mean balance sheet strength is important to the business, but should also help push the P/E a bit higher than it would otherwise be.

The Verdict On China Tobacco International (HK)'s P/E Ratio

China Tobacco International (HK) trades on a P/E ratio of 33.6, which is multiples above its market average of 10.1. Recent earnings growth wasn't bad. And the healthy balance sheet means the company can sustain growth while the P/E suggests shareholders think it will.

When the market is wrong about a stock, it gives savvy investors an opportunity. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. 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.

Of course you might be able to find a better stock than China Tobacco International (HK). So you may wish to see this free collection of other companies that have grown earnings strongly.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.

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. Thank you for reading.