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 China Baofeng (International) Limited's (HKG:3966) P/E ratio could help you assess the value on offer. China Baofeng (International) has a P/E ratio of 2.87, based on the last twelve months. That corresponds to an earnings yield of approximately 35%.

Check out our latest analysis for China Baofeng (International)

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for China Baofeng (International):

P/E of 2.87 = HK$2.5 ÷ HK$0.87 (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 is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.

Does China Baofeng (International) Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio essentially measures market expectations of a company. The image below shows that China Baofeng (International) has a lower P/E than the average (10.7) P/E for companies in the consumer durables industry.

This suggests that market participants think China Baofeng (International) will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.

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. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

China Baofeng (International) increased earnings per share by an impressive 11% over the last twelve months. And it has bolstered its earnings per share by 81% per year over the last five years. With that performance, you might expect an above average P/E ratio.

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

The 'Price' in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. 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).

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 China Baofeng (International)'s Debt Impact Its P/E Ratio?

China Baofeng (International) has net cash of HK$74m. That should lead to a higher P/E than if it did have debt, because its strong balance sheets gives it more options.

The Verdict On China Baofeng (International)'s P/E Ratio

China Baofeng (International)'s P/E is 2.9 which is below average (10.6) in the HK market. The net cash position gives plenty of options to the business, and the recent improvement in EPS is good to see. One might conclude that the market is a bit pessimistic, given the low P/E ratio.

Investors have an opportunity when market expectations about a stock are wrong. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. We don't have analyst forecasts, but shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.

Of course you might be able to find a better stock than China Baofeng (International). So you may wish to see this free collection of other companies that have grown earnings strongly.

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.

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. Thank you for reading.