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 Guangdong Investment Limited's (HKG:270) P/E ratio could help you assess the value on offer. What is Guangdong Investment's P/E ratio? Well, based on the last twelve months it is 22.27. That is equivalent to an earnings yield of about 4.5%.
How Do You Calculate Guangdong Investment's P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Guangdong Investment:
P/E of 22.27 = HK$16.80 ÷ HK$0.75 (Based on the trailing twelve months to September 2019.)
Is A High P/E 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 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 Does Guangdong Investment'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 (5.7) for companies in the water utilities industry is a lot lower than Guangdong Investment's P/E.
That means that the market expects Guangdong Investment will outperform other companies in its industry. 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
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.
Guangdong Investment's earnings per share grew by -2.9% in the last twelve months.
Remember: P/E Ratios Don't Consider The Balance Sheet
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. 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.
Guangdong Investment's Balance Sheet
The extra options and safety that comes with Guangdong Investment's HK$7.2b net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Bottom Line On Guangdong Investment's P/E Ratio
Guangdong Investment has a P/E of 22.3. That's higher than the average in its market, which is 10.2. EPS was up modestly better over the last twelve months. And the healthy balance sheet means the company can sustain growth while the P/E suggests 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. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course you might be able to find a better stock than Guangdong Investment. So you may wish to see this free collection of other companies that have grown earnings strongly.
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 firstname.lastname@example.org. 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.