This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we'll show how Zhong Ao Home Group Limited's (HKG:1538) P/E ratio could help you assess the value on offer. Zhong Ao Home Group has a P/E ratio of 5.09, based on the last twelve months. That corresponds to an earnings yield of approximately 19.7%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for Zhong Ao Home Group:
P/E of 5.09 = HK$0.63 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ HK$0.12 (Based on the year to June 2019.)
Is A High P/E Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.
Does Zhong Ao Home Group Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. We can see in the image below that the average P/E (6.2) for companies in the real estate industry is higher than Zhong Ao Home Group's P/E.
Its relatively low P/E ratio indicates that Zhong Ao Home Group shareholders think it will struggle to do as well as other companies in its industry classification. Since the market seems unimpressed with Zhong Ao Home Group, it's quite possible it could surprise on the upside. 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 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.
Zhong Ao Home Group saw earnings per share improve by -8.7% last year. And earnings per share have improved by 11% annually, over the last five years.
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.
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.
Zhong Ao Home Group's Balance Sheet
Zhong Ao Home Group has net cash of CN¥251m. This is fairly high at 49% 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 Zhong Ao Home Group's P/E Ratio
Zhong Ao Home Group's P/E is 5.1 which is below average (10.3) in the HK market. EPS was up modestly better over the last twelve months. And the healthy balance sheet means the company can sustain growth while the P/E suggests shareholders don't think it will.
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. We don't have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.
Of course you might be able to find a better stock than Zhong Ao Home Group. So you may wish to see this free collection of other companies that have grown earnings strongly.
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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.