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The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll show how you can use China Literature Limited's (HKG:772) P/E ratio to inform your assessment of the investment opportunity. Looking at earnings over the last twelve months, China Literature has a P/E ratio of 28.49. That corresponds to an earnings yield of approximately 3.5%.
See our latest analysis for China Literature
How Do I Calculate China Literature's Price To Earnings Ratio?
The formula for price to earnings is:
Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)
Or for China Literature:
P/E of 28.49 = CN¥28.87 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥1.01 (Based on the trailing twelve months to December 2018.)
Is A High P/E Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.
How Growth Rates Impact P/E Ratios
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. Earnings growth means that in the future the 'E' will be higher. And in that case, the P/E ratio itself will drop rather quickly. And as that P/E ratio drops, the company will look cheap, unless its share price increases.
It's nice to see that China Literature grew EPS by a stonking 37% in the last year.
How Does China Literature's P/E Ratio Compare To Its Peers?
One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. As you can see below, China Literature has a higher P/E than the average company (14.7) in the media industry.
China Literature's P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn't guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.
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. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.