Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how Kowloon Development Company Limited's (HKG:34) P/E ratio could help you assess the value on offer. Kowloon Development has a P/E ratio of 3.76, based on the last twelve months. That means that at current prices, buyers pay HK$3.76 for every HK$1 in trailing yearly profits.
How Do I Calculate Kowloon Development's Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Kowloon Development:
P/E of 3.76 = HK$9.53 ÷ HK$2.54 (Based on the year to June 2019.)
Is A High P/E Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
Does Kowloon Development 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. The image below shows that Kowloon Development has a lower P/E than the average (6.2) P/E for companies in the real estate industry.
Kowloon Development'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. You should delve deeper. I like to check if company insiders have been buying or selling.
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. Earnings growth means that in the future the 'E' will be higher. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Kowloon Development increased earnings per share by a whopping 30% last year. And its annual EPS growth rate over 5 years is 37%. With that performance, I would expect it to have an above average P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
Don't forget that the P/E ratio considers market capitalization. So it won't reflect the advantage of cash, or disadvantage of debt. 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.
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.
How Does Kowloon Development's Debt Impact Its P/E Ratio?
Net debt totals a substantial 127% of Kowloon Development's market cap. This level of debt justifies a relatively low P/E, so remain cognizant of the debt, if you're comparing it to other stocks.
The Bottom Line On Kowloon Development's P/E Ratio
Kowloon Development's P/E is 3.8 which is below average (10.4) in the HK market. While the EPS growth last year was strong, the significant debt levels reduce the number of options available to management. If it continues to grow, then the current low P/E may prove to be unjustified.
Investors have an opportunity when market expectations about a stock are wrong. 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.
But note: Kowloon Development 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.