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 Changmao Biochemical Engineering Company Limited's (HKG:954), to help you decide if the stock is worth further research. Changmao Biochemical Engineering has a P/E ratio of 5.23, based on the last twelve months. That means that at current prices, buyers pay HK$5.23 for every HK$1 in trailing yearly profits.

See our latest analysis for Changmao Biochemical Engineering

How Do You Calculate A 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 Changmao Biochemical Engineering:

P/E of 5.23 = CN¥0.78 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.15 (Based on the trailing twelve months to June 2019.)

Is A High P/E Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. That is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.

How Does Changmao Biochemical Engineering'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 Changmao Biochemical Engineering has a lower P/E than the average (7) P/E for companies in the chemicals industry.

Its relatively low P/E ratio indicates that Changmao Biochemical Engineering shareholders think it will struggle to do as well as other companies in its industry classification. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or 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. Earnings growth means that in the future the 'E' will be higher. That means unless the share price increases, the P/E will reduce in a few years. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

In the last year, Changmao Biochemical Engineering grew EPS like Taylor Swift grew her fan base back in 2010; the 365% gain was both fast and well deserved. And earnings per share have improved by 16% annually, over the last three years. So we'd absolutely expect it to have a relatively high P/E ratio.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn't take debt or cash into account. 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).