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This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Raymond Industrial Limited's (HKG:229), to help you decide if the stock is worth further research. Looking at earnings over the last twelve months, Raymond Industrial has a P/E ratio of 10.17. That is equivalent to an earnings yield of about 9.8%.

See our latest analysis for Raymond Industrial

How Do You Calculate A P/E Ratio?

The formula for P/E is:

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

Or for Raymond Industrial:

P/E of 10.17 = HK$1.07 ÷ HK$0.11 (Based on the trailing twelve months to March 2019.)

Is A High Price-to-Earnings 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.

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. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means unless the share price increases, the P/E will reduce in a few years. Then, a lower P/E should attract more buyers, pushing the share price up.

Raymond Industrial increased earnings per share by a whopping 44% last year. And its annual EPS growth rate over 5 years is 8.7%. I'd therefore be a little surprised if its P/E ratio was not relatively high.

How Does Raymond Industrial's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. You can see in the image below that the average P/E (10.2) for companies in the consumer durables industry is roughly the same as Raymond Industrial's P/E.

Raymond Industrial's P/E tells us that market participants think its prospects are roughly in line with its industry. The company could surprise by performing better than average, in the future. Checking factors such as the tenure of the board and management could help you form your own view on if that will happen.

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

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. 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.

Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).

Raymond Industrial's Balance Sheet

With net cash of HK$215m, Raymond Industrial has a very strong balance sheet, which may be important for its business. Having said that, at 41% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Bottom Line On Raymond Industrial's P/E Ratio

Raymond Industrial trades on a P/E ratio of 10.2, which is fairly close to the HK market average of 10.8. Its net cash position is the cherry on top of its superb EPS growth. So based on this analysis we'd expect Raymond Industrial to have a higher P/E ratio.

Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine.' 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 Raymond Industrial. 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.