Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll apply a basic P/E ratio analysis to Essex Bio-Technology Limited's (HKG:1061), to help you decide if the stock is worth further research. Looking at earnings over the last twelve months, Essex Bio-Technology has a P/E ratio of 9.49. In other words, at today's prices, investors are paying HK$9.49 for every HK$1 in prior year profit.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Essex Bio-Technology:
P/E of 9.49 = HK$4.960 ÷ HK$0.523 (Based on the year to December 2019.)
(Note: the above calculation results may not be precise due to rounding.)
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 necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Does Essex Bio-Technology's P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Essex Bio-Technology has a lower P/E than the average (23.4) P/E for companies in the biotechs industry.
Essex Bio-Technology'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 Essex Bio-Technology, it's quite possible it could surprise on the upside. 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
P/E ratios primarily reflect market expectations around earnings growth rates. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.
It's nice to see that Essex Bio-Technology grew EPS by a stonking 29% in the last year. And it has bolstered its earnings per share by 31% per year over the last five years. I'd therefore be a little surprised if its P/E ratio was not relatively high.
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. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.
How Does Essex Bio-Technology's Debt Impact Its P/E Ratio?
Since Essex Bio-Technology holds net cash of HK$124m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Essex Bio-Technology's P/E Ratio
Essex Bio-Technology has a P/E of 9.5. That's around the same as the average in the HK market, which is 9.7. With a strong balance sheet combined with recent growth, the P/E implies the market is quite pessimistic.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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. We don't have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.
But note: Essex Bio-Technology 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).
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.