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 Sichuan Expressway Company Limited's (HKG:107) P/E ratio could help you assess the value on offer. What is Sichuan Expressway's P/E ratio? Well, based on the last twelve months it is 7.95. That corresponds to an earnings yield of approximately 13%.
How Do I Calculate Sichuan Expressway's Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for Sichuan Expressway:
P/E of 7.95 = CN¥2.21 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.28 (Based on the year to December 2018.)
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. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.'
How Growth Rates Impact P/E Ratios
If earnings fall then in the future the 'E' will be lower. That means even if the current P/E is low, it will increase over time if the share price stays flat. Then, a higher P/E might scare off shareholders, pushing the share price down.
Sichuan Expressway's earnings per share grew by -2.4% in the last twelve months. Unfortunately, earnings per share are down 3.4% a year, over 5 years.
Does Sichuan Expressway Have A Relatively High Or Low P/E For Its Industry?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. If you look at the image below, you can see Sichuan Expressway has a lower P/E than the average (9.4) in the infrastructure industry classification.
Sichuan Expressway'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 Sichuan Expressway, it's quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. So it won't reflect the advantage of cash, or disadvantage of debt. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
Is Debt Impacting Sichuan Expressway's P/E?
Net debt totals a substantial 119% of Sichuan Expressway's market cap. If you want to compare its P/E ratio to other companies, you must keep in mind that these debt levels would usually warrant a relatively low P/E.
The Bottom Line On Sichuan Expressway's P/E Ratio
Sichuan Expressway's P/E is 7.9 which is below average (12) in the HK market. While the recent EPS growth is a positive, the significant amount of debt on the balance sheet may be contributing to pessimistic market expectations.
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. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
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.
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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.