The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll show how you can use NetDragon Websoft Holdings Limited's (HKG:777) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, NetDragon Websoft Holdings's P/E ratio is 11.82. In other words, at today's prices, investors are paying HK$11.82 for every HK$1 in prior year profit.
How Do You Calculate NetDragon Websoft Holdings's P/E Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)
Or for NetDragon Websoft Holdings:
P/E of 11.82 = HK$17.07 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ HK$1.44 (Based on the trailing twelve months to June 2019.)
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. 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 Does NetDragon Websoft Holdings's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. If you look at the image below, you can see NetDragon Websoft Holdings has a lower P/E than the average (13.3) in the entertainment industry classification.
This suggests that market participants think NetDragon Websoft Holdings will underperform other companies in its industry. Since the market seems unimpressed with NetDragon Websoft Holdings, it's quite possible it could surprise on the upside. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
P/E ratios primarily reflect market expectations around earnings growth rates. 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.
NetDragon Websoft Holdings's 392% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. The sweetener is that the annual five year growth rate of 50% is also impressive. So I'd be surprised if the P/E ratio was not above average.
Remember: P/E Ratios Don't Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. So it won't reflect the advantage of cash, or disadvantage of debt. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.
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.
How Does NetDragon Websoft Holdings's Debt Impact Its P/E Ratio?
With net cash of CN¥1.2b, NetDragon Websoft Holdings has a very strong balance sheet, which may be important for its business. Having said that, at 13% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.
The Bottom Line On NetDragon Websoft Holdings's P/E Ratio
NetDragon Websoft Holdings trades on a P/E ratio of 11.8, which is above its market average of 10.3. The excess cash it carries is the gravy on top its fast EPS growth. So based on this analysis we'd expect NetDragon Websoft Holdings to have a high P/E ratio.
Investors have an opportunity when market expectations about a stock are wrong. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free report on the analyst consensus forecasts could help you make a master move on this stock.
Of course you might be able to find a better stock than NetDragon Websoft Holdings. 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.