This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we'll show how Nova LifeStyle, Inc.'s (NASDAQ:NVFY) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, Nova LifeStyle has a P/E ratio of 9.41. That means that at current prices, buyers pay $9.41 for every $1 in trailing yearly profits.
How Do I Calculate A Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Nova LifeStyle:
P/E of 9.41 = $0.69 ÷ $0.073 (Based on the trailing twelve months to June 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 is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
Does Nova LifeStyle Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Nova LifeStyle has a lower P/E than the average (11.5) P/E for companies in the consumer durables industry.
This suggests that market participants think Nova LifeStyle will underperform other companies in its industry. Since the market seems unimpressed with Nova LifeStyle, it's quite possible it could surprise on the upside. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Nova LifeStyle shrunk earnings per share by 72% over the last year. But EPS is up 21% over the last 3 years. And over the longer term (5 years) earnings per share have decreased 25% annually. This growth rate might warrant a below average P/E ratio.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
Don't forget that the P/E ratio considers market capitalization. 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.
How Does Nova LifeStyle's Debt Impact Its P/E Ratio?
With net cash of US$3.1m, Nova LifeStyle has a very strong balance sheet, which may be important for its business. Having said that, at 16% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On Nova LifeStyle's P/E Ratio
Nova LifeStyle has a P/E of 9.4. That's below the average in the US market, which is 17.3. The recent drop in earnings per share would almost certainly temper expectations, the relatively strong balance sheet will allow the company time to invest in growth. If it achieves that, then there's real potential that the low P/E could eventually indicate undervaluation.
Investors have an opportunity when market expectations about a stock are wrong. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. We don't have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.
You might be able to find a better buy than Nova LifeStyle. 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).
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 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. Thank you for reading.