This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll look at Hebei Yichen Industrial Group Corporation Limited's (HKG:1596) P/E ratio and reflect on what it tells us about the company's share price. Hebei Yichen Industrial Group has a P/E ratio of 15.66, based on the last twelve months. In other words, at today's prices, investors are paying HK$15.66 for every HK$1 in prior year profit.
How Do I Calculate A 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 Hebei Yichen Industrial Group:
P/E of 15.66 = CN¥2.73 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.17 (Based on the year 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. 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 Hebei Yichen Industrial Group Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (10.6) for companies in the machinery industry is lower than Hebei Yichen Industrial Group's P/E.
Its relatively high P/E ratio indicates that Hebei Yichen Industrial Group shareholders think it will perform better than other companies in its industry classification. Clearly the market expects growth, but it isn't guaranteed. So investors should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means unless the share price falls, the P/E will increase in a few years. Then, a higher P/E might scare off shareholders, pushing the share price down.
Hebei Yichen Industrial Group had pretty flat EPS growth in the last year. But it has grown its earnings per share by 12% per year over the last five years. And over the longer term (3 years) earnings per share have decreased 25% annually. So you wouldn't expect a very high P/E.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
The 'Price' in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. 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.
While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
Hebei Yichen Industrial Group's Balance Sheet
Since Hebei Yichen Industrial Group holds net cash of CN¥72m, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Hebei Yichen Industrial Group's P/E Ratio
Hebei Yichen Industrial Group trades on a P/E ratio of 15.7, which is above its market average of 10.4. The recent drop in earnings per share might keep value investors away, but the healthy balance sheet means the company retains potential for future growth. If fails to eventuate, the current high P/E could prove to be temporary, as the share price falls.
When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. We don't have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.
But note: Hebei Yichen Industrial Group 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).
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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.