This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at Zhong Hua International Holdings Limited's (HKG:1064) P/E ratio and reflect on what it tells us about the company's share price. What is Zhong Hua International Holdings's P/E ratio? Well, based on the last twelve months it is 7.04. That means that at current prices, buyers pay HK$7.04 for every HK$1 in trailing yearly profits.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Zhong Hua International Holdings:
P/E of 7.04 = HK$0.16 ÷ HK$0.02 (Based on the trailing twelve months to June 2019.)
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. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
Does Zhong Hua International 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 Zhong Hua International Holdings has a higher P/E than the average (6.4) P/E for companies in the real estate industry.
That means that the market expects Zhong Hua International Holdings will outperform other companies in its industry. Clearly the market expects growth, but it isn't guaranteed. So further research is always essential. I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
When earnings fall, the 'E' decreases, over time. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.
Zhong Hua International Holdings shrunk earnings per share by 33% over the last year. And over the longer term (5 years) earnings per share have decreased 10% annually. This growth rate might warrant a below average P/E ratio.
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. So it won't reflect the advantage of cash, or disadvantage of debt. 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.
Is Debt Impacting Zhong Hua International Holdings's P/E?
Zhong Hua International Holdings has net cash of HK$5.8m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Verdict On Zhong Hua International Holdings's P/E Ratio
Zhong Hua International Holdings trades on a P/E ratio of 7.0, which is below the HK market average of 10.3. The recent drop in earnings per share would almost certainly temper expectations, but the net cash position means the company has time to improve: if so, the low P/E could be an opportunity.
Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. We don't have analyst forecasts, but you could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.
Of course you might be able to find a better stock than Zhong Hua International 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 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.