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Here's What Nine Dragons Paper (Holdings) Limited's (HKG:2689) P/E Ratio Is Telling Us

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Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!

Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at Nine Dragons Paper (Holdings) Limited's (HKG:2689) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, Nine Dragons Paper (Holdings) has a P/E ratio of 5.05. In other words, at today's prices, investors are paying HK$5.05 for every HK$1 in prior year profit.

Check out our latest analysis for Nine Dragons Paper (Holdings)

How Do You Calculate Nine Dragons Paper (Holdings)'s P/E Ratio?

The formula for P/E is:

Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)

Or for Nine Dragons Paper (Holdings):

P/E of 5.05 = CN¥6.24 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥1.24 (Based on the trailing twelve months 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 is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.

How Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. When earnings grow, the 'E' increases, over time. 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.

Nine Dragons Paper (Holdings) saw earnings per share decrease by 15% last year. But over the longer term (5 years) earnings per share have increased by 25%.

How Does Nine Dragons Paper (Holdings)'s P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. If you look at the image below, you can see Nine Dragons Paper (Holdings) has a lower P/E than the average (20) in the forestry industry classification.

SEHK:2689 Price Estimation Relative to Market, May 3rd 2019
SEHK:2689 Price Estimation Relative to Market, May 3rd 2019

This suggests that market participants think Nine Dragons Paper (Holdings) will underperform other companies in its industry. 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.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. That means it doesn't take debt or cash into account. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

Nine Dragons Paper (Holdings)'s Balance Sheet

Net debt totals 79% of Nine Dragons Paper (Holdings)'s market cap. This is enough debt that you'd have to make some adjustments before using the P/E ratio to compare it to a company with net cash.

The Verdict On Nine Dragons Paper (Holdings)'s P/E Ratio

Nine Dragons Paper (Holdings) trades on a P/E ratio of 5, which is below the HK market average of 12. Given meaningful debt, and a lack of recent growth, the market looks to be extrapolating this recent performance; reflecting low expectations for the future.

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 report on the analyst consensus forecasts could help you make a master move on this stock.

Of course you might be able to find a better stock than Nine Dragons Paper (Holdings). 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 editorial-team@simplywallst.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.