Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll look at China Everbright Limited's (HKG:165) P/E ratio and reflect on what it tells us about the company's share price. China Everbright has a P/E ratio of 8.51, based on the last twelve months. That means that at current prices, buyers pay HK$8.51 for every HK$1 in trailing yearly profits.

Check out our latest analysis for China Everbright

How Do You Calculate China Everbright's P/E Ratio?

The formula for price to earnings is:

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

Or for China Everbright:

P/E of 8.51 = HK$11.300 ÷ HK$1.327 (Based on the year to December 2019.)

(Note: the above calculation results may not be precise due to rounding.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that investors are paying a higher price for each HK$1 of company earnings. 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 Everbright Have A Relatively High Or Low P/E For Its Industry?

We can get an indication of market expectations by looking at the P/E ratio. The image below shows that China Everbright has a lower P/E than the average (10.4) P/E for companies in the capital markets industry.

China Everbright's P/E tells us that market participants think it will not fare as well as its peers in the same industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

How Growth Rates Impact P/E Ratios

When earnings fall, the 'E' decreases, over time. That means even if the current P/E is low, it will increase over time if the share price stays flat. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.

China Everbright's earnings per share fell by 28% in the last twelve months. And over the longer term (5 years) earnings per share have decreased 2.6% annually. This growth rate might warrant a below average P/E ratio.

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

Don't forget that the P/E ratio considers market capitalization. Thus, the metric does not reflect cash or debt held by the company. In theory, a company can lower its future P/E ratio by using cash or debt to invest in 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).

How Does China Everbright's Debt Impact Its P/E Ratio?

China Everbright's net debt is 84% of its market cap. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.

The Verdict On China Everbright's P/E Ratio

China Everbright trades on a P/E ratio of 8.5, which is below the HK market average of 9.3. When you consider that the company has significant debt, and didn't grow EPS last year, it isn't surprising that the market has muted expectations.

Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. 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.

Of course you might be able to find a better stock than China Everbright. 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.