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 Guangshen Railway Company Limited’s (HKG:525) P/E ratio could help you assess the value on offer. Guangshen Railway has a P/E ratio of 17.63, based on the last twelve months. That corresponds to an earnings yield of approximately 5.7%.
How Do You Calculate Guangshen Railway’s P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for Guangshen Railway:
P/E of 17.63 = CN¥2.72 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.15 (Based on the year to September 2018.)
Is A High P/E 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. 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.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. Earnings growth means that in the future the ‘E’ will be higher. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Guangshen Railway increased earnings per share by an impressive 15% over the last twelve months. And its annual EPS growth rate over 5 years is 1.7%. With that performance, you might expect an above average P/E ratio.
How Does Guangshen Railway’s P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Guangshen Railway has a higher P/E than the average (14.8) P/E for companies in the transportation industry.
That means that the market expects Guangshen Railway will outperform other companies in its industry. 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.
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. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
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).
Guangshen Railway’s Balance Sheet
Since Guangshen Railway holds net cash of CN¥1.9b, it can spend on growth, justifying a higher P/E ratio than otherwise.
The Verdict On Guangshen Railway’s P/E Ratio
Guangshen Railway’s P/E is 17.6 which is above average (10.7) in the HK market. With cash in the bank the company has plenty of growth options — and it is already on the right track. Therefore it seems reasonable that the market would have relatively high expectations of the company
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 report on the analyst consensus forecasts could help you make a master move on this stock.
Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.