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 China Water Industry Group Limited's (HKG:1129), to help you decide if the stock is worth further research. Based on the last twelve months, China Water Industry Group's P/E ratio is 74.04. In other words, at today's prices, investors are paying HK$74.04 for every HK$1 in prior year profit.
See our latest analysis for China Water Industry Group
How Do You Calculate A P/E Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price ÷ Earnings per Share (EPS)
Or for China Water Industry Group:
P/E of 74.04 = HK$0.43 ÷ HK$0.01 (Based on the year to June 2019.)
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. 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 China Water Industry Group 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 China Water Industry Group has a significantly higher P/E than the average (5.7) P/E for companies in the water utilities industry.
Its relatively high P/E ratio indicates that China Water Industry Group 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
Earnings growth rates have a big influence on P/E ratios. When earnings grow, the 'E' increases, over time. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.
China Water Industry Group saw earnings per share decrease by 68% last year. And over the longer term (5 years) earnings per share have decreased 40% annually. This could justify a pessimistic P/E.
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.
Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).
China Water Industry Group's Balance Sheet
China Water Industry Group's net debt equates to 41% of its market capitalization. You'd want to be aware of this fact, but it doesn't bother us.
The Verdict On China Water Industry Group's P/E Ratio
China Water Industry Group's P/E is 74.0 which suggests the market is more focussed on the future opportunity rather than the current level of earnings. With a bit of debt, but a lack of recent growth, it's safe to say the market is expecting improved profit performance from the company, in the next few years.
When the market is wrong about a stock, it gives savvy investors an opportunity. 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.
Of course you might be able to find a better stock than China Water Industry Group. So you may wish to see this free collection of other companies that have grown earnings strongly.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.
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. Thank you for reading.