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Why Shanghai Electric Group Company Limited's (HKG:2727) High P/E Ratio Isn't Necessarily A Bad Thing

Simply Wall St

The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Shanghai Electric Group Company Limited's (HKG:2727), to help you decide if the stock is worth further research. Looking at earnings over the last twelve months, Shanghai Electric Group has a P/E ratio of 11.33. In other words, at today's prices, investors are paying HK$11.33 for every HK$1 in prior year profit.

See our latest analysis for Shanghai Electric Group

How Do You Calculate Shanghai Electric Group's 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 Shanghai Electric Group:

P/E of 11.33 = CN¥2.4 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.21 (Based on the trailing twelve months to March 2019.)

Is A High Price-to-Earnings Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. 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 Shanghai Electric Group's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. You can see in the image below that the average P/E (10.8) for companies in the electrical industry is roughly the same as Shanghai Electric Group's P/E.

SEHK:2727 Price Estimation Relative to Market, July 29th 2019

Its P/E ratio suggests that Shanghai Electric Group shareholders think that in the future it will perform about the same as other companies in its industry classification. So if Shanghai Electric Group actually outperforms its peers going forward, that should be a positive for the share price. Further research into factors such as insider buying and selling, could help you form your own view on whether that is likely.

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means unless the share price increases, the P/E will reduce in a few years. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

Shanghai Electric Group increased earnings per share by 8.6% last year. And its annual EPS growth rate over 5 years is 2.0%.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. In other words, it does not consider any debt or cash that the company may have on the balance sheet. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

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.

So What Does Shanghai Electric Group's Balance Sheet Tell Us?

Since Shanghai Electric Group holds net cash of CN¥2.3b, it can spend on growth, justifying a higher P/E ratio than otherwise.

The Bottom Line On Shanghai Electric Group's P/E Ratio

Shanghai Electric Group's P/E is 11.3 which is about average (10.6) in the HK market. Earnings improved over the last year. And the net cash position gives the company many options. The average P/E suggests the market isn't overly optimistic, though.

Investors have an opportunity when market expectations about a stock are wrong. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.

You might be able to find a better buy than Shanghai Electric 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 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.