This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we'll show how New World Department Store China Limited's (HKG:825) P/E ratio could help you assess the value on offer. New World Department Store China has a price to earnings ratio of 69.69, based on the last twelve months. That is equivalent to an earnings yield of about 1.4%.
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for New World Department Store China:
P/E of 69.69 = HKD1.35 ÷ HKD0.02 (Based on the trailing twelve months to June 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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 New World Department Store China's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (9.8) for companies in the multiline retail industry is a lot lower than New World Department Store China's P/E.
That means that the market expects New World Department Store China will outperform other companies in its industry. 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
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. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.
New World Department Store China's 196% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. Regrettably, the longer term performance is poor, with EPS down 43% per year over 5 years.
Remember: P/E Ratios Don't Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
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 New World Department Store China's Balance Sheet Tell Us?
With net cash of HK$239m, New World Department Store China has a very strong balance sheet, which may be important for its business. Having said that, at 10% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On New World Department Store China's P/E Ratio
New World Department Store China's P/E is 69.7 which suggests the market is more focussed on the future opportunity rather than the current level of earnings. The excess cash it carries is the gravy on top its fast EPS growth. So based on this analysis we'd expect New World Department Store China to have a high P/E ratio.
Investors have an opportunity when market expectations about a stock are wrong. 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: New World Department Store China 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).
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.
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. Thank you for reading.