Today, we’ll introduce the concept of the P/E ratio for those who are learning about investing. We’ll apply a basic P/E ratio analysis to Perfect Shape Medical Limited’s (HKG:1830), to help you decide if the stock is worth further research. Perfect Shape Medical has a price to earnings ratio of 9.61, based on the last twelve months. That corresponds to an earnings yield of approximately 10.4%.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for Perfect Shape Medical:
P/E of 9.61 = HK$2.78 ÷ HK$0.29 (Based on the year 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. That isn’t necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Does Perfect Shape Medical’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. We can see in the image below that the average P/E (17.2) for companies in the consumer services industry is higher than Perfect Shape Medical’s P/E.
This suggests that market participants think Perfect Shape Medical will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or selling.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company’s P/E multiple. When earnings grow, the ‘E’ increases, over time. That means even if the current P/E is high, it will reduce over time if the share price stays flat. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
Perfect Shape Medical’s earnings made like a rocket, taking off 61% last year. The sweetener is that the annual five year growth rate of 28% is also impressive. So I’d be surprised if the P/E ratio was not above average.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. So it won’t reflect the advantage of cash, or disadvantage of debt. 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.
How Does Perfect Shape Medical’s Debt Impact Its P/E Ratio?
Perfect Shape Medical has net cash of HK$458m. This is fairly high at 15% of its market capitalization. That might mean balance sheet strength is important to the business, but should also help push the P/E a bit higher than it would otherwise be.
The Verdict On Perfect Shape Medical’s P/E Ratio
Perfect Shape Medical trades on a P/E ratio of 9.6, which is fairly close to the HK market average of 10.3. The excess cash it carries is the gravy on top its fast EPS growth. So at a glance we’re a bit surprised that Perfect Shape Medical does not have a higher P/E ratio.
Investors should be looking to buy stocks that the market is wrong about. 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. We don’t have analyst forecasts, but you could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.
You might be able to find a better buy than Perfect Shape Medical. 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).
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If you spot an error that warrants correction, please contact the editor at email@example.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.