This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll show how you can use Dawnrays Pharmaceutical (Holdings) Limited's (HKG:2348) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Dawnrays Pharmaceutical (Holdings)'s P/E ratio is 7.41. That is equivalent to an earnings yield of about 13%.
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 Dawnrays Pharmaceutical (Holdings):
P/E of 7.41 = CN¥1.35 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.18 (Based on the year to June 2019.)
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 a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.
Does Dawnrays Pharmaceutical (Holdings) Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio indicates whether the market has higher or lower expectations of a company. We can see in the image below that the average P/E (11.6) for companies in the pharmaceuticals industry is higher than Dawnrays Pharmaceutical (Holdings)'s P/E.
Dawnrays Pharmaceutical (Holdings)'s P/E tells us that market participants think it will not fare as well as its peers in the same industry. Since the market seems unimpressed with Dawnrays Pharmaceutical (Holdings), it's quite possible it could surprise on the upside. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
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. Then, a lower P/E should attract more buyers, pushing the share price up.
Dawnrays Pharmaceutical (Holdings) saw earnings per share decrease by 7.1% last year. But over the longer term (5 years) earnings per share have increased by 11%.
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 expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
Is Debt Impacting Dawnrays Pharmaceutical (Holdings)'s P/E?
Dawnrays Pharmaceutical (Holdings) has net cash of CN¥876m. This is fairly high at 42% of its market capitalization. That might mean balance sheet strength is important to the business, but should also help push the P/E a bit higher than it would otherwise be.
The Bottom Line On Dawnrays Pharmaceutical (Holdings)'s P/E Ratio
Dawnrays Pharmaceutical (Holdings) has a P/E of 7.4. That's below the average in the HK market, which is 10.6. The recent drop in earnings per share would make investors cautious, the relatively strong balance sheet will allow the company time to invest in growth. If it achieves that, then there's real potential that the low P/E could eventually indicate undervaluation.
Investors have an opportunity when market expectations about a stock are wrong. 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. Although we don't have analyst forecasts, shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
But note: Dawnrays Pharmaceutical (Holdings) 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.