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Should You Be Tempted To Sell MECOM Power and Construction Limited (HKG:1183) Because Of Its P/E Ratio?

Simply Wall St

This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll look at MECOM Power and Construction Limited's (HKG:1183) P/E ratio and reflect on what it tells us about the company's share price. MECOM Power and Construction has a price to earnings ratio of 29.25, based on the last twelve months. That is equivalent to an earnings yield of about 3.4%.

Check out our latest analysis for MECOM Power and Construction

How Do I Calculate A Price To Earnings Ratio?

The formula for P/E is:

Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)

Or for MECOM Power and Construction:

P/E of 29.25 = HK$0.95 (Note: this is the share price in the reporting currency, namely, MOP ) ÷ HK$0.03 (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 necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.

Does MECOM Power and Construction 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 MECOM Power and Construction has a higher P/E than the average (10.1) P/E for companies in the construction industry.

SEHK:1183 Price Estimation Relative to Market, November 7th 2019

That means that the market expects MECOM Power and Construction will outperform other companies in its industry. The market is optimistic about the future, but that doesn't guarantee future growth. 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

If earnings fall then in the future the 'E' will be lower. That means unless the share price falls, the P/E will increase in a few years. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.

MECOM Power and Construction's earnings per share fell by 49% in the last twelve months. And EPS is down 16% a year, over the last 5 years. This might lead to muted expectations.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

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.

So What Does MECOM Power and Construction's Balance Sheet Tell Us?

With net cash of MO$270m, MECOM Power and Construction has a very strong balance sheet, which may be important for its business. Having said that, at 24% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Verdict On MECOM Power and Construction's P/E Ratio

MECOM Power and Construction has a P/E of 29.2. That's higher than the average in its market, which is 10.5. Falling earnings per share is probably keeping traditional value investors away, but the net cash position means the company has time to improve: and the high P/E suggests the market thinks it will.

Investors have an opportunity when market expectations about a stock are wrong. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. We don't have analyst forecasts, but you might want to assess this data-rich visualization of earnings, revenue and cash flow.

But note: MECOM Power and Construction 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).

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 editorial-team@simplywallst.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.