This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we'll show how Vico International Holdings Limited's (HKG:1621) P/E ratio could help you assess the value on offer. Vico International Holdings has a price to earnings ratio of 6.37, based on the last twelve months. In other words, at today's prices, investors are paying HK$6.37 for every HK$1 in prior year profit.

Check out our latest analysis for Vico International Holdings

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

Price to Earnings Ratio = Price per Share ÷ Earnings per Share (EPS)

Or for Vico International Holdings:

P/E of 6.37 = HKD0.13 ÷ HKD0.02 (Based on the trailing twelve months to September 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each HKD1 the company has earned over the last year. 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 Vico International Holdings's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. The image below shows that Vico International Holdings has a P/E ratio that is roughly in line with the oil and gas industry average (6.4).

Vico International Holdings's P/E tells us that market participants think its prospects are roughly in line with its industry. The company could surprise by performing better than average, in the future. Further research into factors such as insider buying and selling, could help you form your own view on whether that is likely.

How Growth Rates Impact P/E Ratios

Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means even if the current P/E is low, it will increase over time if the share price stays flat. Then, a higher P/E might scare off shareholders, pushing the share price down.

Vico International Holdings's earnings made like a rocket, taking off 66% last year. Regrettably, the longer term performance is poor, with EPS down -7.6% per year over 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.