This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we'll show how Anhui Expressway Company Limited's (HKG:995) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, Anhui Expressway has a P/E ratio of 6.01. That means that at current prices, buyers pay HK$6.01 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 Anhui Expressway:
P/E of 6.01 = CN¥4.04 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.67 (Based on the trailing twelve months to June 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.
Does Anhui Expressway 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. If you look at the image below, you can see Anhui Expressway has a lower P/E than the average (8.8) in the infrastructure industry classification.
This suggests that market participants think Anhui Expressway will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
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. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. And in that case, the P/E ratio itself will drop rather quickly. Then, a lower P/E should attract more buyers, pushing the share price up.
Anhui Expressway had pretty flat EPS growth in the last year. But EPS is up 6.2% over the last 5 years.
Remember: P/E Ratios Don't Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. 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 Anhui Expressway's Debt Impact Its P/E Ratio?
Since Anhui Expressway holds net cash of CN¥491m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Anhui Expressway's P/E Ratio
Anhui Expressway has a P/E of 6. That's below the average in the HK market, which is 10. The recent drop in earnings per share would almost certainly temper expectations, the healthy balance sheet means the company retains potential for future growth. If that occurs, the current low P/E could prove to be temporary.
Investors should be looking to buy stocks that the market is wrong about. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course you might be able to find a better stock than Anhui Expressway. 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.