Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how Novacon Technology Group Limited's (HKG:8635) P/E ratio could help you assess the value on offer. What is Novacon Technology Group's P/E ratio? Well, based on the last twelve months it is 8.68. That corresponds to an earnings yield of approximately 12%.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Novacon Technology Group:
P/E of 8.68 = HK$0.17 ÷ HK$0.019 (Based on the trailing twelve months to June 2019.)
Is A High P/E 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 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 Novacon Technology Group's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. If you look at the image below, you can see Novacon Technology Group has a lower P/E than the average (13.3) in the software industry classification.
Novacon Technology Group's P/E tells us that market participants think it will not fare as well as its peers in the same industry. Since the market seems unimpressed with Novacon Technology Group, 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
Probably the most important factor in determining what P/E a company trades on is the earnings growth. Earnings growth means that in the future the 'E' will be higher. And in that case, the P/E ratio itself will drop rather quickly. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
It's great to see that Novacon Technology Group grew EPS by 23% in the last year.
Remember: P/E Ratios Don't Consider The Balance Sheet
The 'Price' in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
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 Novacon Technology Group's Debt Impact Its P/E Ratio?
Novacon Technology Group's net debt is 2.0% of its market cap. So it doesn't have as many options as it would with net cash, but its debt would not have much of an impact on its P/E ratio.
The Verdict On Novacon Technology Group's P/E Ratio
Novacon Technology Group trades on a P/E ratio of 8.7, which is below the HK market average of 10.4. The company does have a little debt, and EPS growth was good last year. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.
Investors should be looking to buy stocks that the market is wrong about. 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.' 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.
You might be able to find a better buy than Novacon Technology Group. 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.