Want to participate in a short research study? Help shape the future of investing tools and receive a $20 prize!
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 Shenhua Energy Company Limited’s (HKG:1088) P/E ratio could help you assess the value on offer. China Shenhua Energy has a P/E ratio of 7.06, based on the last twelve months. In other words, at today’s prices, investors are paying HK$7.06 for every HK$1 in prior year profit.
How Do You Calculate China Shenhua Energy’s P/E 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 China Shenhua Energy:
P/E of 7.06 = CN¥16.47 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥2.33 (Based on the trailing twelve months to September 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. 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 Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.
China Shenhua Energy’s earnings per share grew by -3.5% in the last twelve months. And it has improved its earnings per share by 37% per year over the last three years.
How Does China Shenhua Energy’s P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. If you look at the image below, you can see China Shenhua Energy has a lower P/E than the average (11.5) in the oil and gas industry classification.
Its relatively low P/E ratio indicates that China Shenhua Energy shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with China Shenhua Energy, it’s quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don’t forget that the P/E ratio considers market capitalization. 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.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
China Shenhua Energy’s Balance Sheet
The extra options and safety that comes with China Shenhua Energy’s CN¥33b net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Bottom Line On China Shenhua Energy’s P/E Ratio
China Shenhua Energy trades on a P/E ratio of 7.1, which is below the HK market average of 10.5. EPS was up modestly better over the last twelve months. Also positive, the relatively strong balance sheet will allow for investment in growth. In contrast, the P/E indicates shareholders doubt that will happen!
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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
But note: China Shenhua Energy may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio 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. On rare occasion, data errors may occur. Thank you for reading.