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 Zheshang Bank Co., Ltd's (HKG:2016) P/E ratio could help you assess the value on offer. China Zheshang Bank has a P/E ratio of 5.92, based on the last twelve months. That means that at current prices, buyers pay HK$5.92 for every HK$1 in trailing yearly profits.
How Do I Calculate China Zheshang Bank's Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)
Or for China Zheshang Bank:
P/E of 5.92 = HK$4.00 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ HK$0.68 (Based on the trailing twelve months to September 2019.)
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. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
How Does China Zheshang Bank's P/E Ratio Compare To Its Peers?
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 Zheshang Bank has a P/E ratio that is roughly in line with the banks industry average (5.9).
That indicates that the market expects China Zheshang Bank will perform roughly in line with other companies in its industry. If the company has better than average prospects, then the market might be underestimating it. I would further inform my view by checking insider buying and selling., among other things.
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. 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. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Most would be impressed by China Zheshang Bank earnings growth of 14% in the last year. And its annual EPS growth rate over 5 years is 8.2%. This could arguably justify a relatively high P/E ratio.
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. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
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.
Is Debt Impacting China Zheshang Bank's P/E?
China Zheshang Bank's net debt is 59% of its market cap. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.
The Verdict On China Zheshang Bank's P/E Ratio
China Zheshang Bank trades on a P/E ratio of 5.9, which is below the HK market average of 10.5. The company has a meaningful amount of debt on the balance sheet, but that should not eclipse the solid earnings growth. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.
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. Although we don't have analyst forecasts shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than China Zheshang Bank. 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 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.