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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 Smart-Core Holdings Limited's (HKG:2166), to help you decide if the stock is worth further research. Based on the last twelve months, Smart-Core Holdings's P/E ratio is 10.04. In other words, at today's prices, investors are paying HK$10.04 for every HK$1 in prior year profit.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Smart-Core Holdings:
P/E of 10.04 = HK$1.62 ÷ HK$0.16 (Based on the year to December 2018.)
Is A High Price-to-Earnings 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 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 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. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Smart-Core Holdings's earnings per share grew by -4.0% in the last twelve months. And its annual EPS growth rate over 5 years is 123%.
Does Smart-Core Holdings Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Smart-Core Holdings has a P/E ratio that is roughly in line with the electronic industry average (10.3).
That indicates that the market expects Smart-Core Holdings will perform roughly in line with other companies in its industry. So if Smart-Core Holdings actually outperforms its peers going forward, that should be a positive for the share price. Checking factors such as the tenure of the board and management could help you form your own view on if that will happen.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The 'Price' in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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).
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
Is Debt Impacting Smart-Core Holdings's P/E?
Smart-Core Holdings has net cash of HK$156m. This is fairly high at 19% of its market capitalization. That might mean balance sheet strength is important to the business, but should also help push the P/E a bit higher than it would otherwise be.
The Verdict On Smart-Core Holdings's P/E Ratio
Smart-Core Holdings trades on a P/E ratio of 10, which is below the HK market average of 10.9. Earnings improved over the last year. Also positive, the relatively strong balance sheet will allow for investment in growth. In contrast, the P/E indicates shareholders doubt that will happen!
Investors should be looking to buy stocks that the market is wrong about. 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.' Although we don't have analyst forecasts, shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than Smart-Core Holdings. 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.