Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll apply a basic P/E ratio analysis to IBO Technology Company Limited's (HKG:2708), to help you decide if the stock is worth further research. Looking at earnings over the last twelve months, IBO Technology has a P/E ratio of 21.85. That means that at current prices, buyers pay HK$21.85 for every HK$1 in trailing yearly profits.

View our latest analysis for IBO Technology

How Do You Calculate A P/E Ratio?

The formula for P/E is:

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

Or for IBO Technology:

P/E of 21.85 = HK$1.85 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ HK$0.08 (Based on the trailing twelve months to March 2019.)

Is A High P/E Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

Does IBO Technology Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (12.0) for companies in the it industry is lower than IBO Technology's P/E.

Its relatively high P/E ratio indicates that IBO Technology shareholders think it will perform better than other companies in its industry classification. The market is optimistic about the future, but that doesn't guarantee future growth. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

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. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

IBO Technology's earnings per share fell by 22% in the last twelve months. But EPS is up 21% over the last 5 years.

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. 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).

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.

IBO Technology's Balance Sheet

The extra options and safety that comes with IBO Technology's CN¥17m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.

The Bottom Line On IBO Technology's P/E Ratio

IBO Technology has a P/E of 21.8. That's higher than the average in its market, which is 10.3. Falling earnings per share is probably keeping traditional value investors away, but the relatively strong balance sheet will allow the company time to invest in growth. Clearly, the high P/E indicates shareholders think it will!

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 IBO Technology. 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.