Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use China Petroleum & Chemical Corporation's (HKG:386) P/E ratio to inform your assessment of the investment opportunity. China Petroleum & Chemical has a P/E ratio of 9.48, based on the last twelve months. In other words, at today's prices, investors are paying HK$9.48 for every HK$1 in prior year profit.
How Do I Calculate China Petroleum & Chemical's 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 China Petroleum & Chemical:
P/E of 9.48 = CN¥4.53 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.48 (Based on the trailing twelve months to March 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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.'
How Does China Petroleum & Chemical's P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. As you can see below, China Petroleum & Chemical has a higher P/E than the average company (8.4) in the oil and gas industry.
China Petroleum & Chemical's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn't guaranteed. So further research is always essential. I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. 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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
China Petroleum & Chemical increased earnings per share by 8.5% last year. And its annual EPS growth rate over 3 years is 16%. But earnings per share are down 2.6% per year over the last five years.
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 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.
China Petroleum & Chemical's Balance Sheet
The extra options and safety that comes with China Petroleum & Chemical's CN¥413m 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 China Petroleum & Chemical's P/E Ratio
China Petroleum & Chemical has a P/E of 9.5. That's below the average in the HK market, which is 10.7. Recent earnings growth wasn't bad. And the healthy balance sheet means the company can sustain growth while the P/E suggests shareholders don't think it will.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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 firstname.lastname@example.org. 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.