Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use Fire Rock Holdings Limited's (HKG:1909) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Fire Rock Holdings's P/E ratio is 13.15. In other words, at today's prices, investors are paying HK$13.15 for every HK$1 in prior year profit.
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 Fire Rock Holdings:
P/E of 13.15 = CN¥4.7 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.36 (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 Fire Rock Holdings Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. As you can see below Fire Rock Holdings has a P/E ratio that is fairly close for the average for the entertainment industry, which is 13.2.
Its P/E ratio suggests that Fire Rock Holdings shareholders think that in the future it will perform about the same as other companies in its industry classification. So if Fire Rock Holdings actually outperforms its peers going forward, that should be a positive for the share price. Further research into factors such as insider buying and selling, could help you form your own view on whether that is likely.
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. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. 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.
In the last year, Fire Rock Holdings grew EPS like Taylor Swift grew her fan base back in 2010; the 94% gain was both fast and well deserved. The sweetener is that the annual five year growth rate of 53% is also impressive. With that kind of growth rate we would generally expect a high P/E ratio.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
The 'Price' in P/E reflects the market capitalization of the company. That means it doesn't take debt or cash into account. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
So What Does Fire Rock Holdings's Balance Sheet Tell Us?
Fire Rock Holdings has net cash of CN¥192m. This is fairly high at 13% 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 Fire Rock Holdings's P/E Ratio
Fire Rock Holdings's P/E is 13.2 which is above average (10.7) in its market. 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. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. Although we don't have analyst forecasts, you might want to assess this data-rich visualization of earnings, revenue and cash flow.
You might be able to find a better buy than Fire Rock Holdings. 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 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.