This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Weichai Power Co., Ltd.'s (HKG:2338), to help you decide if the stock is worth further research. Weichai Power has a P/E ratio of 11.19, based on the last twelve months. That corresponds to an earnings yield of approximately 8.9%.
How Do You Calculate Weichai Power's P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for Weichai Power:
P/E of 11.19 = HK$13.69 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ HK$1.22 (Based on the trailing twelve months to September 2019.)
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 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 Weichai Power Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. As you can see below, Weichai Power has a higher P/E than the average company (10.2) in the machinery industry.
Its relatively high P/E ratio indicates that Weichai Power shareholders think it will perform better than other companies in its industry classification. Shareholders are clearly optimistic, but the future is always uncertain. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. Earnings growth means that in the future the 'E' will be higher. That means unless the share price increases, the P/E will reduce in a few years. 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 Weichai Power grew EPS by 20% in the last year. And it has bolstered its earnings per share by 13% per year over the last five years. So one might expect an above average P/E ratio.
Remember: P/E Ratios Don't Consider The Balance Sheet
Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. 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.
How Does Weichai Power's Debt Impact Its P/E Ratio?
Weichai Power has net cash of CN¥9.5b. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Bottom Line On Weichai Power's P/E Ratio
Weichai Power has a P/E of 11.2. That's around the same as the average in the HK market, which is 10.5. With a strong balance sheet combined with recent growth, the P/E implies the market is quite pessimistic.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.
You might be able to find a better buy than Weichai Power. 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).
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.