The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at Shanghai Fudan-Zhangjiang Bio-Pharmaceutical Co., Ltd.'s (HKG:1349) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, Shanghai Fudan-Zhangjiang Bio-Pharmaceutical has a P/E ratio of 18.29. That corresponds to an earnings yield of approximately 5.5%.
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 Shanghai Fudan-Zhangjiang Bio-Pharmaceutical:
P/E of 18.29 = CN¥4.504 ÷ CN¥0.246 (Based on the trailing twelve months to December 2019.)
(Note: the above calculation uses the share price in the reporting currency, namely CNY and the calculation results may not be precise due to rounding.)
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 Does Shanghai Fudan-Zhangjiang Bio-Pharmaceutical's P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. As you can see below, Shanghai Fudan-Zhangjiang Bio-Pharmaceutical has a higher P/E than the average company (10.6) in the pharmaceuticals industry.
Its relatively high P/E ratio indicates that Shanghai Fudan-Zhangjiang Bio-Pharmaceutical shareholders think it will perform better than other companies in its industry classification. Clearly the market expects growth, but it isn't guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. 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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Shanghai Fudan-Zhangjiang Bio-Pharmaceutical's 103% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. Even better, EPS is up 18% per year over three years. So you might say it really deserves to have an above-average P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
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).
Shanghai Fudan-Zhangjiang Bio-Pharmaceutical's Balance Sheet
Shanghai Fudan-Zhangjiang Bio-Pharmaceutical has net cash of CN¥428m. This is fairly high at 10% 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 Shanghai Fudan-Zhangjiang Bio-Pharmaceutical's P/E Ratio
Shanghai Fudan-Zhangjiang Bio-Pharmaceutical trades on a P/E ratio of 18.3, which is above its market average of 9.3. The excess cash it carries is the gravy on top its fast EPS growth. So based on this analysis we'd expect Shanghai Fudan-Zhangjiang Bio-Pharmaceutical to have a high P/E ratio.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. Although we don't have analyst forecasts shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
Of course you might be able to find a better stock than Shanghai Fudan-Zhangjiang Bio-Pharmaceutical. So you may wish to see this free collection of other companies that have grown earnings strongly.
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.
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.