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Why Prosperous Industrial (Holdings) Limited's (HKG:1731) High P/E Ratio Isn't Necessarily A Bad Thing

Simply Wall St

This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at Prosperous Industrial (Holdings) Limited's (HKG:1731) P/E ratio and reflect on what it tells us about the company's share price. Based on the last twelve months, Prosperous Industrial (Holdings)'s P/E ratio is 38.8. That is equivalent to an earnings yield of about 2.6%.

View our latest analysis for Prosperous Industrial (Holdings)

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

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

Or for Prosperous Industrial (Holdings):

P/E of 38.8 = $0.18 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $0.0045 (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 Prosperous Industrial (Holdings) Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Prosperous Industrial (Holdings) has a significantly higher P/E than the average (8.8) P/E for companies in the luxury industry.

SEHK:1731 Price Estimation Relative to Market, September 14th 2019

Prosperous Industrial (Holdings)'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

When earnings fall, the 'E' decreases, over time. That means even if the current P/E is low, it will increase over time if the share price stays flat. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.

Prosperous Industrial (Holdings) saw earnings per share decrease by 62% last year. And it has shrunk its earnings per share by 23% per year over the last five years. This might lead to muted expectations.

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. 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.

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).

Prosperous Industrial (Holdings)'s Balance Sheet

Prosperous Industrial (Holdings) has net cash of US$37m. This is fairly high at 18% of its market capitalization. That might mean balance sheet strength is important to the business, but should also help push the P/E a bit higher than it would otherwise be.

The Bottom Line On Prosperous Industrial (Holdings)'s P/E Ratio

Prosperous Industrial (Holdings) has a P/E of 38.8. That's significantly higher than the average in its market, which is 10.6. Falling earnings per share is probably keeping traditional value investors away, but the relatively strong balance sheet will allow the company time to invest in growth. Clearly, the high P/E indicates shareholders think it will!

Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. Although we don't have analyst forecasts, you might want to assess this data-rich visualization of earnings, revenue and cash flow.

But note: Prosperous Industrial (Holdings) 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.