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Today, we’ll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we’ll show how China Traditional Chinese Medicine Holdings Co. Limited’s (HKG:570) P/E ratio could help you assess the value on offer. China Traditional Chinese Medicine Holdings has a P/E ratio of 11.37, based on the last twelve months. That means that at current prices, buyers pay HK$11.37 for every HK$1 in trailing yearly profits.
How Do You Calculate China Traditional Chinese Medicine Holdings’s 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 Traditional Chinese Medicine Holdings:
P/E of 11.37 = CN¥3.39 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.30 (Based on the year to December 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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
Generally speaking the rate of earnings growth has a profound impact on a company’s P/E multiple. If earnings are growing quickly, then the ‘E’ in the equation will increase faster than it would otherwise. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.
Most would be impressed by China Traditional Chinese Medicine Holdings earnings growth of 13% in the last year. And its annual EPS growth rate over 5 years is 25%. This could arguably justify a relatively high P/E ratio.
How Does China Traditional Chinese Medicine Holdings’s P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (12.3) for companies in the pharmaceuticals industry is roughly the same as China Traditional Chinese Medicine Holdings’s P/E.
That indicates that the market expects China Traditional Chinese Medicine Holdings will perform roughly in line with other companies in its industry. The company could surprise by performing better than average, in the future. 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
The ‘Price’ in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future) by investing in growth. That means taking on debt (or spending its cash).
While growth expenditure doesn’t always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.
China Traditional Chinese Medicine Holdings’s Balance Sheet
The extra options and safety that comes with China Traditional Chinese Medicine Holdings’s CN¥329m 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 Traditional Chinese Medicine Holdings’s P/E Ratio
China Traditional Chinese Medicine Holdings trades on a P/E ratio of 11.4, which is fairly close to the HK market average of 10.9. With a strong balance sheet combined with recent growth, the P/E implies the market is quite pessimistic. Since analysts are predicting growth will continue, one might expect to see a higher P/E so it may be worth looking closer.
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 visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.
But note: China Traditional Chinese Medicine Holdings 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 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.