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 Telecom Corporation Limited's (HKG:728) P/E ratio could help you assess the value on offer. China Telecom has a P/E ratio of 13.28, based on the last twelve months. That corresponds to an earnings yield of approximately 7.5%.
How Do I Calculate China Telecom's Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for China Telecom:
P/E of 13.28 = CN¥3.48 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.26 (Based on the year to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each HK$1 the company has earned over the last year. That isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
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. When earnings grow, the 'E' increases, over time. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
China Telecom increased earnings per share by an impressive 14% over the last twelve months. And it has bolstered its earnings per share by 3.9% per year over the last five years. With that performance, you might expect an above average P/E ratio.
Does China Telecom Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. The image below shows that China Telecom has a lower P/E than the average (14.9) P/E for companies in the telecom industry.
China Telecom's P/E tells us that market participants think it will not fare as well as its peers in the same industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
Remember: P/E Ratios Don't Consider The Balance Sheet
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. Thus, the metric does not reflect cash or debt held by the company. 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).
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).
How Does China Telecom's Debt Impact Its P/E Ratio?
Net debt is 25% of China Telecom's market cap. While that's enough to warrant consideration, it doesn't really concern us.
The Bottom Line On China Telecom's P/E Ratio
China Telecom's P/E is 13.3 which is above average (12.1) in the HK market. While the company does use modest debt, its recent earnings growth is very good. So on this analysis it seems reasonable that its P/E ratio is above average.
Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
You might be able to find a better buy than China Telecom. 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 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.