Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at Lee & Man Chemical Company Limited's (HKG:746) P/E ratio and reflect on what it tells us about the company's share price. Lee & Man Chemical has a price to earnings ratio of 3.86, based on the last twelve months. That means that at current prices, buyers pay HK$3.86 for every HK$1 in trailing yearly profits.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Lee & Man Chemical:
P/E of 3.86 = HK$4.08 ÷ HK$1.06 (Based on the year to December 2018.)
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 isn't necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Does Lee & Man Chemical's P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. We can see in the image below that the average P/E (7.5) for companies in the chemicals industry is higher than Lee & Man Chemical's P/E.
Its relatively low P/E ratio indicates that Lee & Man Chemical shareholders think it will struggle to do as well as other companies in its industry classification. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or selling.
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 even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
It's great to see that Lee & Man Chemical grew EPS by 24% in the last year. And it has bolstered its earnings per share by 23% per year over the last five years. This could arguably justify a relatively high P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
The 'Price' in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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).
How Does Lee & Man Chemical's Debt Impact Its P/E Ratio?
Net debt is 38% of Lee & Man Chemical's market cap. While it's worth keeping this in mind, it isn't a worry.
The Bottom Line On Lee & Man Chemical's P/E Ratio
Lee & Man Chemical's P/E is 3.9 which is below average (10.6) in the HK market. The company does have a little debt, and EPS growth was good last year. The low P/E ratio suggests current market expectations are muted, implying these levels of growth will not continue.
Investors should be looking to buy stocks that the market is wrong about. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. We don't have analyst forecasts, but you could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than Lee & Man Chemical. 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.