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 Tong Ren Tang Technologies Co. Ltd.'s (HKG:1666), to help you decide if the stock is worth further research. Tong Ren Tang Technologies has a price to earnings ratio of 13.97, based on the last twelve months. That corresponds to an earnings yield of approximately 7.2%.
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 Tong Ren Tang Technologies:
P/E of 13.97 = HK$6.85 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ HK$0.49 (Based on the trailing twelve months to June 2019.)
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. 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'.
How Does Tong Ren Tang Technologies's P/E Ratio Compare To Its Peers?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. You can see in the image below that the average P/E (11.6) for companies in the pharmaceuticals industry is lower than Tong Ren Tang Technologies's P/E.
Its relatively high P/E ratio indicates that Tong Ren Tang Technologies shareholders think it will perform better than other companies in its industry classification. Clearly the market expects growth, but it isn't guaranteed. So investors 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. 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. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Tong Ren Tang Technologies's earnings per share fell by 8.1% in the last twelve months. But it has grown its earnings per share by 7.5% per year over the last five years.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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.
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).
Tong Ren Tang Technologies's Balance Sheet
With net cash of CN¥2.8b, Tong Ren Tang Technologies has a very strong balance sheet, which may be important for its business. Having said that, at 32% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Verdict On Tong Ren Tang Technologies's P/E Ratio
Tong Ren Tang Technologies's P/E is 14.0 which is above average (10.5) in its market. The recent drop in earnings per share might keep value investors away, but the net cash position means the company has time to improve: and the high P/E suggests the market thinks it will.
When the market is wrong about a stock, it gives savvy investors an opportunity. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. 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 Tong Ren Tang Technologies. 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).
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.
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