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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 Chongqing Machinery & Electric Co., Ltd.'s (HKG:2722) P/E ratio could help you assess the value on offer. Chongqing Machinery & Electric has a price to earnings ratio of 5.36, based on the last twelve months. That corresponds to an earnings yield of approximately 19%.
How Do I Calculate A 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 Chongqing Machinery & Electric:
P/E of 5.36 = CN¥0.64 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.12 (Based on the trailing twelve months to December 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. 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
P/E ratios primarily reflect market expectations around earnings growth rates. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means even if the current P/E is high, it will reduce over time if the share price stays flat. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Chongqing Machinery & Electric increased earnings per share by a whopping 33% last year. And its annual EPS growth rate over 3 years is 1.9%. I'd therefore be a little surprised if its P/E ratio was not relatively high. But earnings per share are down 2.7% per year over the last five years.
Does Chongqing Machinery & Electric 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 Chongqing Machinery & Electric has a lower P/E than the average (7.2) P/E for companies in the industrials industry.
This suggests that market participants think Chongqing Machinery & Electric will underperform other companies in its 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.
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. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
Chongqing Machinery & Electric's Balance Sheet
Chongqing Machinery & Electric's net debt equates to 25% of its market capitalization. While that's enough to warrant consideration, it doesn't really concern us.
The Verdict On Chongqing Machinery & Electric's P/E Ratio
Chongqing Machinery & Electric trades on a P/E ratio of 5.4, which is below the HK market average of 12. The company hasn't stretched its balance sheet, and earnings growth was good last year. If it continues to grow, then the current low P/E may prove to be unjustified.
Investors should be looking to buy stocks that the market is wrong about. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. Although we don't have analyst forecasts, shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
But note: Chongqing Machinery & Electric 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. Thank you for reading.