This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll show how you can use CAA Resources Limited's (HKG:2112) P/E ratio to inform your assessment of the investment opportunity. What is CAA Resources's P/E ratio? Well, based on the last twelve months it is 73.98. That corresponds to an earnings yield of approximately 1.4%.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for CAA Resources:
P/E of 73.98 = $0.12 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $0.0017 (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. 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 CAA Resources 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. As you can see below, CAA Resources has a much higher P/E than the average company (10.4) in the trade distributors industry.
CAA Resources's P/E tells us that market participants think the company will perform better than its industry peers, going forward. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. 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.
CAA Resources saw earnings per share decrease by 26% last year. But EPS is up 60% over the last 3 years. And EPS is down 35% a year, over the last 5 years. This growth rate might warrant a below average P/E ratio.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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 CAA Resources's P/E?
Net debt totals 64% of CAA Resources's market cap. This is enough debt that you'd have to make some adjustments before using the P/E ratio to compare it to a company with net cash.
The Bottom Line On CAA Resources's P/E Ratio
CAA Resources's P/E is 74 which suggests the market is more focussed on the future opportunity rather than the current level of earnings. With significant debt and no EPS growth last year, shareholders are betting on an improvement in earnings from the company.
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 shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than CAA Resources. 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).
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.