This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll look at Frontage Holdings Corporation's (HKG:1521) P/E ratio and reflect on what it tells us about the company's share price. Frontage Holdings has a price to earnings ratio of 40.19, based on the last twelve months. That is equivalent to an earnings yield of about 2.5%.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for Frontage Holdings:
P/E of 40.19 = $0.46 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $0.011 (Based on the year to June 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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.
How Does Frontage Holdings's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. The image below shows that Frontage Holdings has a lower P/E than the average (45.1) P/E for companies in the life sciences industry.
Frontage Holdings's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Many investors like to buy stocks when the market is pessimistic about their prospects. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
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. 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.
In the last year, Frontage Holdings grew EPS like Taylor Swift grew her fan base back in 2010; the 61% gain was both fast and well deserved. The cherry on top is that the five year growth rate was an impressive 19% per year. With that kind of growth rate we would generally expect a high P/E ratio.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. So it won't reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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.
So What Does Frontage Holdings's Balance Sheet Tell Us?
Frontage Holdings has net cash of US$210m. This is fairly high at 22% 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 Verdict On Frontage Holdings's P/E Ratio
Frontage Holdings trades on a P/E ratio of 40.2, which is multiples above its market average of 9.8. Its net cash position is the cherry on top of its superb EPS growth. So based on this analysis we'd expect Frontage Holdings to have a high P/E ratio.
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.' So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
But note: Frontage 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).
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If you spot an error that warrants correction, please contact the editor at email@example.com. 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.