The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we’ll show how China Xinhua Education Group Limited’s (HKG:2779) P/E ratio could help you assess the value on offer. Based on the last twelve months, China Xinhua Education Group’s P/E ratio is 18.19. In other words, at today’s prices, investors are paying HK$18.19 for every HK$1 in prior year profit.
How Do You Calculate A P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for China Xinhua Education Group:
P/E of 18.19 = CN¥2.34 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.13 (Based on the trailing twelve months 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. 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 Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. When earnings grow, the ‘E’ increases, over time. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
China Xinhua Education Group shrunk earnings per share by 12% over the last year.
How Does China Xinhua Education 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 China Xinhua Education Group has a P/E ratio that is fairly close for the average for the consumer services industry, which is 18.8.
Its P/E ratio suggests that China Xinhua Education Group shareholders think that in the future it will perform about the same as other companies in its industry classification. The company could surprise by performing better than average, in the future. I inform my view byby checking management tenure and remuneration, among other things.
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 taking on debt (or spending its remaining cash).
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.
China Xinhua Education Group’s Balance Sheet
The extra options and safety that comes with China Xinhua Education Group’s CN¥1.6b net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.
The Verdict On China Xinhua Education Group’s P/E Ratio
China Xinhua Education Group has a P/E of 18.2. That’s higher than the average in the HK market, which is 10.8. The recent drop in earnings per share might keep value investors away, but the net cash position means the company has time to improve: and the high P/E suggests the market thinks it will.
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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
You might be able to find a better buy than China Xinhua Education Group. 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 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.