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This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Greentown Service Group Co. Ltd.’s (HKG:2869) P/E ratio could help you assess the value on offer. Greentown Service Group has a price to earnings ratio of 38.19, based on the last twelve months. In other words, at today’s prices, investors are paying HK$38.19 for every HK$1 in prior year profit.
How Do I Calculate Greentown Service Group’s Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)
Or for Greentown Service Group:
P/E of 38.19 = CN¥6.04 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.16 (Based on the year to June 2018.)
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
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.
Greentown Service Group increased earnings per share by a whopping 29% last year. And its annual EPS growth rate over 5 years is 20%. With that performance, I would expect it to have an above average P/E ratio.
How Does Greentown Service Group’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. As you can see below, Greentown Service Group has a higher P/E than the average company (12.8) in the commercial services industry.
Its relatively high P/E ratio indicates that Greentown Service Group shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn’t guarantee future growth. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
The ‘Price’ in P/E reflects the market capitalization of the company. That means it doesn’t take debt or cash into account. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
Greentown Service Group’s Balance Sheet
The extra options and safety that comes with Greentown Service Group’s CN¥1.8b 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 Greentown Service Group’s P/E Ratio
Greentown Service Group trades on a P/E ratio of 38.2, which is multiples above the HK market average of 10.5. Its net cash position supports a higher P/E ratio, as does its solid recent earnings growth. So it is not surprising the market is probably extrapolating recent growth well into the future, reflected in the relatively high P/E ratio.
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: Greentown Service Group 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).
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.