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Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll apply a basic P/E ratio analysis to China Mengniu Dairy Company Limited's (HKG:2319), to help you decide if the stock is worth further research. Based on the last twelve months, China Mengniu Dairy's P/E ratio is 32.53. In other words, at today's prices, investors are paying HK$32.53 for every HK$1 in prior year profit.
How Do You Calculate China Mengniu Dairy's P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for China Mengniu Dairy:
P/E of 32.53 = CN¥25.35 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.78 (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 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
P/E ratios primarily reflect market expectations around earnings growth rates. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means unless the share price increases, the P/E will reduce in a few years. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
It's nice to see that China Mengniu Dairy grew EPS by a stonking 48% in the last year. And earnings per share have improved by 12% annually, over the last five years. I'd therefore be a little surprised if its P/E ratio was not relatively high.
Does China Mengniu Dairy Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. The image below shows that China Mengniu Dairy has a higher P/E than the average (15.3) P/E for companies in the food industry.
China Mengniu Dairy's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn't guaranteed. So further research is always essential. I often monitor director buying and selling.
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. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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 China Mengniu Dairy's P/E?
The extra options and safety that comes with China Mengniu Dairy's CN¥2.2b 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 China Mengniu Dairy's P/E Ratio
China Mengniu Dairy has a P/E of 32.5. That's higher than the average in the HK market, which is 11.1. Its net cash position is the cherry on top of its superb EPS growth. To us, this is the sort of company that we would expect to carry an above average price tag (relative to earnings).
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.' So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
You might be able to find a better buy than China Mengniu Dairy. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).
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.