The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We’ll show how you can use Luk Fook Holdings (International) Limited’s (HKG:590) P/E ratio to inform your assessment of the investment opportunity. Luk Fook Holdings (International) has a price to earnings ratio of 8.59, based on the last twelve months. That is equivalent to an earnings yield of about 12%.

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How Do I Calculate Luk Fook Holdings (International)’s Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for Luk Fook Holdings (International):

P/E of 8.59 = HK$22.15 ÷ HK$2.58 (Based on the year to September 2018.)

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. 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. Earnings growth means that in the future the ‘E’ will be higher. 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.

Luk Fook Holdings (International) increased earnings per share by a whopping 37% last year. And it has improved its earnings per share by 12% per year over the last three years. With that performance, I would expect it to have an above average P/E ratio. Unfortunately, earnings per share are down 8.8% a year, over 5 years.

How Does Luk Fook Holdings (International)’s P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. The image below shows that Luk Fook Holdings (International) has a P/E ratio that is roughly in line with the specialty retail industry average (8.7).

Its P/E ratio suggests that Luk Fook Holdings (International) shareholders think that in the future it will perform about the same as other companies in its industry classification. If the company has better than average prospects, then the market might be underestimating it. I inform my view byby checking management tenure and remuneration, among other things.

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

The ‘Price’ in P/E reflects the market capitalization of the company. In other words, it does not consider any debt or cash that the company may have on the balance sheet. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining cash).

Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

Is Debt Impacting Luk Fook Holdings (International)’s P/E?

Net debt totals just 0.9% of Luk Fook Holdings (International)’s market cap. The market might award it a higher P/E ratio if it had net cash, but its unlikely this low level of net borrowing is having a big impact on the P/E multiple.

The Verdict On Luk Fook Holdings (International)’s P/E Ratio

Luk Fook Holdings (International)’s P/E is 8.6 which is below average (10.3) in the HK market. The company hasn’t stretched its balance sheet, and earnings growth was good last year. If it continues to grow, then the current low P/E may prove to be unjustified.

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.’ So this free report on the analyst consensus forecasts could help you make a master move on this stock.

Of course you might be able to find a better stock than Luk Fook Holdings (International). So you may wish to see this free collection of other companies that have grown earnings strongly.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.