Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how Galaxy Entertainment Group Limited's (HKG:27) P/E ratio could help you assess the value on offer. Galaxy Entertainment Group has a price to earnings ratio of 17.75, based on the last twelve months. In other words, at today's prices, investors are paying HK$17.75 for every HK$1 in prior year profit.
How Do You Calculate Galaxy Entertainment Group's P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)
Or for Galaxy Entertainment Group:
P/E of 17.75 = HK$53.25 ÷ HK$3 (Based on the year to June 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each HK$1 the company has earned over the last year. 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 Galaxy Entertainment Group's P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. As you can see below, Galaxy Entertainment Group has a higher P/E than the average company (11.4) in the hospitality industry.
Galaxy Entertainment Group'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 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
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. 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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Galaxy Entertainment Group shrunk earnings per share by 1.2% last year. But EPS is up 2.2% over the last 5 years.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The 'Price' in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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).
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.
Galaxy Entertainment Group's Balance Sheet
Galaxy Entertainment Group has net cash of HK$7.5b. 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 Galaxy Entertainment Group's P/E Ratio
Galaxy Entertainment Group has a P/E of 17.7. That's higher than the average in its market, which is 10.4. The recent drop in earnings per share would make some investors cautious, 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.
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. 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 Galaxy Entertainment Group. 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.