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 Dawnrays Pharmaceutical (Holdings) Limited's (HKG:2348) P/E ratio could help you assess the value on offer. What is Dawnrays Pharmaceutical (Holdings)'s P/E ratio? Well, based on the last twelve months it is 6.06. That is equivalent to an earnings yield of about 16.5%.

View our latest analysis for Dawnrays Pharmaceutical (Holdings)

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for Dawnrays Pharmaceutical (Holdings):

P/E of 6.06 = CN¥1.101 ÷ CN¥0.182 (Based on the year to June 2019.)

(Note: the above calculation uses the share price in the reporting currency, namely CNY and the 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 CN¥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.

How Does Dawnrays Pharmaceutical (Holdings)'s P/E Ratio Compare To Its Peers?

The P/E ratio indicates whether the market has higher or lower expectations of a company. If you look at the image below, you can see Dawnrays Pharmaceutical (Holdings) has a lower P/E than the average (10.1) in the pharmaceuticals industry classification.

Dawnrays Pharmaceutical (Holdings)'s P/E tells us that market participants think it will not fare as well as its peers in the same industry. Many investors like to buy stocks when the market is pessimistic about their prospects. 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

Earnings growth rates have a big influence on P/E ratios. When earnings grow, the 'E' increases, over time. 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.

Dawnrays Pharmaceutical (Holdings) shrunk earnings per share by 7.1% last year. But over the longer term (5 years) earnings per share have increased by 11%.

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

Don't forget that the P/E ratio considers market capitalization. So it won't reflect the advantage of cash, or disadvantage of debt. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.

How Does Dawnrays Pharmaceutical (Holdings)'s Debt Impact Its P/E Ratio?

With net cash of CN¥901m, Dawnrays Pharmaceutical (Holdings) has a very strong balance sheet, which may be important for its business. Having said that, at 50% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Verdict On Dawnrays Pharmaceutical (Holdings)'s P/E Ratio

Dawnrays Pharmaceutical (Holdings) has a P/E of 6.1. That's below the average in the HK market, which is 9.3. Falling earnings per share are likely to be keeping potential buyers away, but the net cash position means the company has time to improve: if so, the low P/E could be an opportunity.

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. Although we don't have analyst forecasts 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 Dawnrays Pharmaceutical (Holdings). 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.