The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how Luzhou Xinglu Water (Group) Co., Ltd.'s (HKG:2281) P/E ratio could help you assess the value on offer. Luzhou Xinglu Water (Group) has a P/E ratio of 5.68, based on the last twelve months. That means that at current prices, buyers pay HK$5.68 for every HK$1 in trailing yearly profits.
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 Luzhou Xinglu Water (Group):
P/E of 5.68 = HK$1.20 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ HK$0.21 (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 necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Does Luzhou Xinglu Water (Group)'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 Luzhou Xinglu Water (Group) has a P/E ratio that is roughly in line with the water utilities industry average (5.7).
That indicates that the market expects Luzhou Xinglu Water (Group) will perform roughly in line with other companies in its industry. The company could surprise by performing better than average, in the future. Further research into factors such as insider buying and selling, could help you form your own view on whether that is likely.
How Growth Rates Impact P/E Ratios
If earnings fall then in the future the 'E' will be lower. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. Then, a higher P/E might scare off shareholders, pushing the share price down.
Most would be impressed by Luzhou Xinglu Water (Group) earnings growth of 23% in the last year. And its annual EPS growth rate over 5 years is 2.7%. So one might expect an above average P/E ratio. In contrast, EPS has decreased by 1.1%, annually, over 3 years.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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).
How Does Luzhou Xinglu Water (Group)'s Debt Impact Its P/E Ratio?
Luzhou Xinglu Water (Group)'s net debt is 66% of its market cap. This is a reasonably significant level of debt -- all else being equal you'd expect a much lower P/E than if it had net cash.
The Verdict On Luzhou Xinglu Water (Group)'s P/E Ratio
Luzhou Xinglu Water (Group) has a P/E of 5.7. That's below the average in the HK market, which is 10.2. While the EPS growth last year was strong, the significant debt levels reduce the number of options available to management. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.
Investors have an opportunity when market expectations about a stock are wrong. 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. Although we don't have analyst forecasts you might want to assess this data-rich visualization of earnings, revenue and cash flow.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
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.