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 Chongqing Iron & Steel Company Limited's (HKG:1053) P/E ratio could help you assess the value on offer. What is Chongqing Iron & Steel's P/E ratio? Well, based on the last twelve months it is 7.70. That means that at current prices, buyers pay HK$7.70 for every HK$1 in trailing yearly profits.
How Do I Calculate Chongqing Iron & Steel's Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)
Or for Chongqing Iron & Steel:
P/E of 7.70 = HK$0.89 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ HK$0.12 (Based on the trailing twelve months to September 2019.)
Is A High P/E 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 is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
Does Chongqing Iron & Steel Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio indicates whether the market has higher or lower expectations of a company. If you look at the image below, you can see Chongqing Iron & Steel has a lower P/E than the average (10.4) in the metals and mining industry classification.
This suggests that market participants think Chongqing Iron & Steel will underperform other companies in its industry. Many investors like to buy stocks when the market is pessimistic about their prospects. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
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. Earnings growth means that in the future the 'E' will be higher. 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.
Chongqing Iron & Steel shrunk earnings per share by 51% over the last year.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. So it won't reflect the advantage of cash, or disadvantage of debt. 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).
While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
How Does Chongqing Iron & Steel's Debt Impact Its P/E Ratio?
Chongqing Iron & Steel has net debt worth 11% of its market capitalization. This could bring some additional risk, and reduce the number of investment options for management; worth remembering if you compare its P/E to businesses without debt.
The Bottom Line On Chongqing Iron & Steel's P/E Ratio
Chongqing Iron & Steel has a P/E of 7.7. That's below the average in the HK market, which is 10.5. The debt levels are not a major concern, but the lack of EPS growth is likely weighing on sentiment.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
But note: Chongqing Iron & Steel may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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.
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. Thank you for reading.