The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll show how you can use Hong Kong Exchanges and Clearing Limited's (HKG:388) P/E ratio to inform your assessment of the investment opportunity. What is Hong Kong Exchanges and Clearing's P/E ratio? Well, based on the last twelve months it is 30.33. That corresponds to an earnings yield of approximately 3.3%.
How Do You Calculate Hong Kong Exchanges and Clearing's P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Hong Kong Exchanges and Clearing:
P/E of 30.33 = HK$230.2 ÷ HK$7.59 (Based on the year to June 2019.)
Is A High P/E 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.'
Does Hong Kong Exchanges and Clearing 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 (12.9) for companies in the capital markets industry is lower than Hong Kong Exchanges and Clearing's P/E.
Hong Kong Exchanges and Clearing's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn't guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
Hong Kong Exchanges and Clearing saw earnings per share improve by -4.8% last year. And it has bolstered its earnings per share by 14% per year over the last five years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
Don't forget that the P/E ratio considers market capitalization. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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.
Hong Kong Exchanges and Clearing's Balance Sheet
Since Hong Kong Exchanges and Clearing holds net cash of HK$27b, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Hong Kong Exchanges and Clearing's P/E Ratio
Hong Kong Exchanges and Clearing's P/E is 30.3 which is above average (10.5) in its market. Recent earnings growth wasn't bad. And the healthy balance sheet means the company can sustain growth while the P/E suggests shareholders think it will.
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.' So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
You might be able to find a better buy than Hong Kong Exchanges and Clearing. 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).
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 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.