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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how Alibaba Group Holding Limited's (NYSE:BABA) P/E ratio could help you assess the value on offer. Based on the last twelve months, Alibaba Group Holding's P/E ratio is 35.28. That means that at current prices, buyers pay $35.28 for every $1 in trailing yearly profits.
How Do I Calculate Alibaba Group Holding's Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)
Or for Alibaba Group Holding:
P/E of 35.28 = CN¥1197.78 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥33.95 (Based on the year to March 2019.)
Is A High Price-to-Earnings Ratio Good?
The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
How Does Alibaba Group Holding's P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. You can see in the image below that the average P/E (35.3) for companies in the online retail industry is roughly the same as Alibaba Group Holding's P/E.
That indicates that the market expects Alibaba Group Holding will perform roughly in line with other companies in its industry. If the company has better than average prospects, then the market might be underestimating it. 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
Earnings growth rates have a big influence on P/E ratios. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. 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.
Alibaba Group Holding increased earnings per share by a whopping 35% last year. And earnings per share have improved by 26% annually, over the last five years. With that performance, I would expect it to have an above average P/E ratio.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. 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.
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 Alibaba Group Holding's Balance Sheet Tell Us?
The extra options and safety that comes with Alibaba Group Holding's CN¥69b 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 Alibaba Group Holding's P/E Ratio
Alibaba Group Holding has a P/E of 35.3. That's higher than the average in its market, which is 18. Its net cash position is the cherry on top of its superb EPS growth. So based on this analysis we'd expect Alibaba Group Holding to have a high P/E ratio.
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.
Of course you might be able to find a better stock than Alibaba Group Holding. So you may wish to see this free collection of other companies that have grown earnings strongly.
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.