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 G & M Holdings Limited’s (HKG:6038) P/E ratio could help you assess the value on offer. G & M Holdings has a price to earnings ratio of 5.25, based on the last twelve months. That is equivalent to an earnings yield of about 19%.

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How Do I Calculate A Price To Earnings Ratio?

The formula for P/E is:

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

Or for G & M Holdings:

P/E of 5.25 = HK$0.27 ÷ HK$0.050 (Based on the trailing twelve months to June 2018.)

Is A High P/E Ratio Good?

A higher P/E ratio means that investors are paying a higher price for each HK$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 Growth Rates Impact P/E Ratios

P/E ratios primarily reflect market expectations around earnings growth rates. When earnings grow, the ‘E’ increases, over time. That means unless the share price increases, the P/E will reduce in a few years. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

G & M Holdings’s earnings per share fell by 21% in the last twelve months. And it has shrunk its earnings per share by 6.1% per year over the last five years. This growth rate might warrant a below average P/E ratio.

How Does G & M Holdings’s P/E Ratio Compare To Its Peers?

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 G & M Holdings has a lower P/E than the average (11.2) in the construction industry classification.

G & M 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. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

Remember: P/E Ratios Don’t Consider The Balance Sheet

Don’t forget that the P/E ratio considers market capitalization. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.