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This article is written for those who want to get better at using price to earnings ratios (P/E ratios). To keep it practical, we'll show how Great Wall Motor Company Limited's (HKG:2333) P/E ratio could help you assess the value on offer. Great Wall Motor has a price to earnings ratio of 10.59, based on the last twelve months. In other words, at today's prices, investors are paying HK$10.59 for every HK$1 in prior year profit.
View our latest analysis for Great Wall Motor
How Do You Calculate Great Wall Motor's 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 Great Wall Motor:
P/E of 10.59 = CN¥4.52 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.43 (Based on the trailing twelve months to March 2019.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each HK$1 the company has earned over the last year. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.'
Does Great Wall Motor 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 Great Wall Motor has a higher P/E than the average (9.3) P/E for companies in the auto industry.
That means that the market expects Great Wall Motor will outperform other companies in its industry. The market is optimistic about the future, but that doesn't guarantee future growth. So further research is always essential. I often monitor director buying and selling.
How Growth Rates Impact P/E Ratios
If earnings fall then in the future the 'E' will be lower. That means unless the share price falls, the P/E will increase in a few years. A higher P/E should indicate the stock is expensive relative to others -- and that may encourage shareholders to sell.
Great Wall Motor saw earnings per share decrease by 24% last year. And it has shrunk its earnings per share by 14% per year over the last five years. This could justify a pessimistic P/E.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. In other words, it does not consider any debt or cash that the company may have on the balance sheet. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.