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Why Zhongsheng Group Holdings Limited's (HKG:881) High P/E Ratio Isn't Necessarily A Bad Thing

Simply Wall St

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 Zhongsheng Group Holdings Limited's (HKG:881) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, Zhongsheng Group Holdings has a P/E ratio of 16.00. That means that at current prices, buyers pay HK$16.00 for every HK$1 in trailing yearly profits.

Check out our latest analysis for Zhongsheng Group Holdings

How Do You Calculate Zhongsheng Group Holdings's P/E Ratio?

The formula for P/E is:

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

Or for Zhongsheng Group Holdings:

P/E of 16.00 = CNY27.33 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CNY1.71 (Based on the trailing twelve months to June 2019.)

Is A High P/E Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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'.

Does Zhongsheng Group Holdings Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (11.1) for companies in the specialty retail industry is lower than Zhongsheng Group Holdings's P/E.

SEHK:881 Price Estimation Relative to Market, January 23rd 2020

Its relatively high P/E ratio indicates that Zhongsheng Group Holdings 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 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

Earnings growth rates have a big influence on P/E ratios. When earnings grow, the 'E' increases, over time. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.

Zhongsheng Group Holdings maintained roughly steady earnings over the last twelve months. But over the longer term (5 years) earnings per share have increased by 26%.

Don't Forget: The P/E Does Not Account For Debt or Bank Deposits

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won't reflect the advantage of cash, or disadvantage of debt. 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).

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.

Zhongsheng Group Holdings's Balance Sheet

Net debt is 28% of Zhongsheng Group Holdings's market cap. You'd want to be aware of this fact, but it doesn't bother us.

The Verdict On Zhongsheng Group Holdings's P/E Ratio

Zhongsheng Group Holdings has a P/E of 16.0. That's higher than the average in its market, which is 10.5. Given the debt is only modest, and earnings are already moving in the right direction, it's not surprising that the market expects continued improvement.

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 report on the analyst consensus forecasts could help you make a master move on this stock.

But note: Zhongsheng Group 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).

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.

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. Thank you for reading.