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 Li & Fung Limited’s (HKG:494) P/E ratio could help you assess the value on offer. Based on the last twelve months, Li & Fung’s P/E ratio is 10.35. That is equivalent to an earnings yield of about 9.7%.
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How Do You Calculate Li & Fung’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 Li & Fung:
P/E of 10.35 = $0.16 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $0.015 (Based on the year to December 2018.)
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 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 Growth Rates Impact P/E Ratios
When earnings fall, the ‘E’ decreases, over time. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. Then, a higher P/E might scare off shareholders, pushing the share price down.
Li & Fung saw earnings per share decrease by 24% last year. And it has shrunk its earnings per share by 27% per year over the last five years. This growth rate might warrant a below average P/E ratio.
Does Li & Fung Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. As you can see below Li & Fung has a P/E ratio that is fairly close for the average for the luxury industry, which is 10.
Li & Fung’s P/E tells us that market participants think its prospects are roughly in line with its industry. If the company has better than average prospects, then the market might be underestimating it. Further research into factors such asmanagement tenure, could help you form your own view on whether that is likely.
A Limitation: P/E Ratios Ignore Debt and Cash In The Bank
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. 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.
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.
Is Debt Impacting Li & Fung’s P/E?
Net debt is 31% of Li & Fung’s market cap. You’d want to be aware of this fact, but it doesn’t bother us.
The Verdict On Li & Fung’s P/E Ratio
Li & Fung has a P/E of 10.3. That’s around the same as the average in the HK market, which is 11.1. Given it has some debt, but didn’t grow last year, the P/E indicates the market is expecting higher profits ahead for the business.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
But note: Li & Fung 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 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.