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This article is for investors who would like to improve their understanding of 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. What is Guangshen Railway's P/E ratio? Well, based on the last twelve months it is 23.42. In other words, at today's prices, investors are paying HK$23.42 for every HK$1 in prior year profit.
How Do I Calculate Guangshen Railway's Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)
Or for Guangshen Railway:
P/E of 23.42 = CN¥2.41 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.10 (Based on the year to March 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 Growth Rates Impact P/E Ratios
Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means even if the current P/E is low, it will increase over time if the share price stays flat. Then, a higher P/E might scare off shareholders, pushing the share price down.
Guangshen Railway's earnings per share fell by 38% in the last twelve months. And EPS is down 8.0% a year, over the last 5 years. This might lead to muted expectations.
How Does Guangshen Railway'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 (21) for companies in the transportation industry is lower than Guangshen Railway's P/E.
Its relatively high P/E ratio indicates that Guangshen Railway shareholders think it will perform better than other companies in its industry classification. 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.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
The 'Price' in P/E reflects the market capitalization of the company. That means it doesn't take debt or cash into account. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.
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.
Is Debt Impacting Guangshen Railway's P/E?
Guangshen Railway has net cash of CN¥1.5b. 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 Guangshen Railway's P/E Ratio
Guangshen Railway has a P/E of 23.4. That's higher than the average in the HK market, which is 10.8. The recent drop in earnings per share would make some investors cautious, but the net cash position means the company has time to improve: and the high P/E suggests the market thinks it will.
When the market is wrong about a stock, it gives savvy investors an opportunity. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
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.
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.