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 Sunfonda Group Holdings Limited's (HKG:1771) P/E ratio could help you assess the value on offer. Sunfonda Group Holdings has a price to earnings ratio of 3.16, based on the last twelve months. In other words, at today's prices, investors are paying HK$3.16 for every HK$1 in prior year profit.
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for Sunfonda Group Holdings:
P/E of 3.16 = CNY0.98 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CNY0.31 (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 Sunfonda Group Holdings 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. The image below shows that Sunfonda Group Holdings has a lower P/E than the average (11.3) P/E for companies in the specialty retail industry.
This suggests that market participants think Sunfonda Group Holdings will underperform other companies in its industry. Since the market seems unimpressed with Sunfonda Group Holdings, 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.
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. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Sunfonda Group Holdings saw earnings per share improve by -4.3% last year. And earnings per share have improved by 167% annually, over the last three years. But earnings per share are down 8.6% per year over the last five years.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
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. 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.
Sunfonda Group Holdings's Balance Sheet
Net debt totals a substantial 181% of Sunfonda Group Holdings's market cap. This level of debt justifies a relatively low P/E, so remain cognizant of the debt, if you're comparing it to other stocks.
The Verdict On Sunfonda Group Holdings's P/E Ratio
Sunfonda Group Holdings trades on a P/E ratio of 3.2, which is below the HK market average of 10.4. The meaningful debt load is probably contributing to low expectations, even though it has improved earnings recently.
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 shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
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.
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.
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