The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at Xiaomi Corporation's (HKG:1810) P/E ratio and reflect on what it tells us about the company's share price. What is Xiaomi's P/E ratio? Well, based on the last twelve months it is 30.91. In other words, at today's prices, investors are paying HK$30.91 for every HK$1 in prior year profit.
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How Do You Calculate Xiaomi's P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for Xiaomi:
P/E of 30.91 = CN¥11.801 ÷ CN¥0.382 (Based on the year to March 2020.)
(Note: the above calculation uses the share price in the reporting currency, namely CNY and the calculation results may not be precise due to rounding.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each CN¥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.
Does Xiaomi Have A Relatively High Or Low P/E For Its Industry?
The P/E ratio essentially measures market expectations of a company. The image below shows that Xiaomi has a significantly higher P/E than the average (9.5) P/E for companies in the tech industry.
Its relatively high P/E ratio indicates that Xiaomi shareholders think it will perform better than other companies in its industry classification. Clearly the market expects growth, but it isn't guaranteed. So further research is always essential. I often monitor director buying and selling.
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. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Xiaomi saw earnings per share decrease by 68% last year. But EPS is up 88% over the last 3 years.
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. That means it doesn't take debt or cash into account. 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 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.
Xiaomi's Balance Sheet
Xiaomi has net cash of CN¥36b. This is fairly high at 13% 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 Bottom Line On Xiaomi's P/E Ratio
Xiaomi has a P/E of 30.9. That's significantly higher than the average in its market, which is 9.5. Falling earnings per share is probably keeping traditional 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 should be looking to buy stocks that the market is wrong about. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.
Of course you might be able to find a better stock than Xiaomi. So you may wish to see this free collection of other companies that have grown earnings strongly.
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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned. Thank you for reading.