This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We’ll show how you can use Beijing Chunlizhengda Medical Instruments Co Ltd’s (HKG:1858) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Beijing Chunlizhengda Medical Instruments’s P/E ratio is 18.7. That is equivalent to an earnings yield of about 5.3%.

See our latest analysis for Beijing Chunlizhengda Medical Instruments

How Do You Calculate A P/E Ratio?

The formula for P/E is:

Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)

Or for Beijing Chunlizhengda Medical Instruments:

P/E of 18.7 = CN¥22.58 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥1.21 (Based on the trailing twelve months to June 2018.)

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 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

Probably the most important factor in determining what P/E a company trades on is the earnings growth. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.

It’s nice to see that Beijing Chunlizhengda Medical Instruments grew EPS by a stonking 33% in the last year. And earnings per share have improved by 12% annually, over the last five years. With that performance, I would expect it to have an above average P/E ratio.

How Does Beijing Chunlizhengda Medical Instruments’s P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. We can see in the image below that the average P/E (21) for companies in the medical equipment industry is higher than Beijing Chunlizhengda Medical Instruments’s P/E.

Beijing Chunlizhengda Medical Instruments’s P/E tells us that market participants think it will not fare as well as its peers in the same industry. Since the market seems unimpressed with Beijing Chunlizhengda Medical Instruments, it’s quite possible it could surprise on the upside. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.

Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits

The ‘Price’ in P/E reflects the market capitalization of the company. 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.

Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

How Does Beijing Chunlizhengda Medical Instruments’s Debt Impact Its P/E Ratio?

Since Beijing Chunlizhengda Medical Instruments holds net cash of CN¥389m, it can spend on growth, justifying a higher P/E ratio than otherwise.

The Bottom Line On Beijing Chunlizhengda Medical Instruments’s P/E Ratio

Beijing Chunlizhengda Medical Instruments trades on a P/E ratio of 18.7, which is above the HK market average of 10.7. With cash in the bank the company has plenty of growth options — and it is already on the right track. Therefore it seems reasonable that the market would have relatively high expectations of the company

When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. So this free report on the analyst consensus forecasts could help you make a master move on this stock.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.