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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at Chinasoft International Limited's (HKG:354) P/E ratio and reflect on what it tells us about the company's share price. Chinasoft International has a price to earnings ratio of 10.84, based on the last twelve months. That corresponds to an earnings yield of approximately 9.2%.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for Chinasoft International:
P/E of 10.84 = CN¥3.2 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.30 (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 is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
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 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.
Notably, Chinasoft International grew EPS by a whopping 25% in the last year. And it has bolstered its earnings per share by 29% per year over the last five years. With that performance, I would expect it to have an above average P/E ratio.
How Does Chinasoft International's P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Chinasoft International has a P/E ratio that is roughly in line with the it industry average (11.5).
Chinasoft International's P/E tells us that market participants think its prospects are roughly in line with its industry. If the company has better than average prospects, then the market might be underestimating it. Checking factors such as the tenure of the board and management could help you form your own view on if that will happen.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
The 'Price' in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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).
Chinasoft International's Balance Sheet
Chinasoft International has net cash of CN¥286m. 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 Chinasoft International's P/E Ratio
Chinasoft International's P/E is 10.8 which is about average (10.8) in the HK market. Considering its recent growth, alongside its lack of debt, it would appear that the market isn't very excited about the future. Since analysts are predicting growth will continue, one might expect to see a higher P/E so it may be worth looking closer.
Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
But note: Chinasoft International may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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.