This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to China Life Insurance Company Limited's (HKG:2628), to help you decide if the stock is worth further research. Looking at earnings over the last twelve months, China Life Insurance has a P/E ratio of 15.59. That means that at current prices, buyers pay HK$15.59 for every HK$1 in trailing yearly profits.
How Do I Calculate China Life Insurance's 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 China Life Insurance:
P/E of 15.59 = HK$17.75 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ HK$1.14 (Based on the trailing twelve months to June 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that investors are paying a higher price for each HK$1 of company earnings. 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 Does China Life Insurance's P/E Ratio Compare To Its Peers?
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 China Life Insurance has a higher P/E than the average (10.3) P/E for companies in the insurance industry.
China Life Insurance's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Shareholders are clearly optimistic, but the future is always uncertain. So investors should delve deeper. I like to check if company insiders have been buying or 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. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. And in that case, the P/E ratio itself will drop rather quickly. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
China Life Insurance's earnings per share fell by 11% in the last twelve months. But over the longer term (5 years) earnings per share have increased by 3.6%.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. That means it doesn't take debt or cash into account. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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).
So What Does China Life Insurance's Balance Sheet Tell Us?
China Life Insurance has net cash of CN¥38b. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.
The Verdict On China Life Insurance's P/E Ratio
China Life Insurance trades on a P/E ratio of 15.6, which is above its market average of 10.4. Falling earnings per share is probably keeping traditional value investors away, but the relatively strong balance sheet will allow the company time to invest in growth. Clearly, the high P/E indicates shareholders think it will!
Investors have an opportunity when market expectations about a stock are wrong. 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. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
Of course you might be able to find a better stock than China Life Insurance. 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 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.