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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 Anhui Expressway Company Limited's (HKG:995) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, Anhui Expressway has a P/E ratio of 6.01. That means that at current prices, buyers pay HK$6.01 for every HK$1 in trailing yearly profits.
Check out our latest analysis for Anhui Expressway
How Do I Calculate A Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for Anhui Expressway:
P/E of 6.01 = CN¥4.04 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.67 (Based on the trailing twelve months to June 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 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.
Does Anhui Expressway Have A Relatively High Or Low P/E For Its Industry?
We can get an indication of market expectations by looking at the P/E ratio. If you look at the image below, you can see Anhui Expressway has a lower P/E than the average (8.8) in the infrastructure industry classification.
This suggests that market participants think Anhui Expressway 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
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. And in that case, the P/E ratio itself will drop rather quickly. Then, a lower P/E should attract more buyers, pushing the share price up.
Anhui Expressway had pretty flat EPS growth in the last year. But EPS is up 6.2% over the last 5 years.
Remember: P/E Ratios Don't Consider The Balance Sheet
One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. Thus, the metric does not reflect cash or debt held by the company. 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).