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This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at Prosperous Industrial (Holdings) Limited's (HKG:1731) P/E ratio and reflect on what it tells us about the company's share price. Based on the last twelve months, Prosperous Industrial (Holdings)'s P/E ratio is 19.34. In other words, at today's prices, investors are paying HK$19.34 for every HK$1 in prior year profit.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)
Or for Prosperous Industrial (Holdings):
P/E of 19.34 = $0.15 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $0.0076 (Based on the year to December 2018.)
Is A High P/E 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 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 Growth Rates Impact P/E Ratios
When earnings fall, the 'E' decreases, over time. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.
Prosperous Industrial (Holdings) shrunk earnings per share by 70% over the last year. And EPS is down 15% a year, over the last 3 years. This might lead to low expectations.
How Does Prosperous Industrial (Holdings)'s P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. As you can see below, Prosperous Industrial (Holdings) has a higher P/E than the average company (10.6) in the luxury industry.
That means that the market expects Prosperous Industrial (Holdings) will outperform other companies in its industry. Shareholders are clearly optimistic, but the future is always uncertain. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The 'Price' in P/E reflects the market capitalization of the company. That means it doesn't take debt or cash into account. 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.
Is Debt Impacting Prosperous Industrial (Holdings)'s P/E?
The extra options and safety that comes with Prosperous Industrial (Holdings)'s US$64m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Verdict On Prosperous Industrial (Holdings)'s P/E Ratio
Prosperous Industrial (Holdings) trades on a P/E ratio of 19.3, which is above the HK market average of 12.2. Falling earnings per share is probably keeping traditional value investors away, but the relatively strong balance sheet will allow the company time to invest in growth. Clearly, the high P/E indicates shareholders think it will!
When the market is wrong about a stock, it gives savvy investors an opportunity. 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.' We don't have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E 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.