This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We'll look at Longfor Group Holdings Limited's (HKG:960) P/E ratio and reflect on what it tells us about the company's share price. Looking at earnings over the last twelve months, Longfor Group Holdings has a P/E ratio of 10.17. That means that at current prices, buyers pay HK$10.17 for every HK$1 in trailing yearly profits.

See our latest analysis for Longfor Group Holdings

How Do You Calculate Longfor Group Holdings's P/E Ratio?

The formula for price to earnings is:

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

Or for Longfor Group Holdings:

P/E of 10.17 = HK$29.76 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ HK$2.93 (Based on the trailing twelve months to June 2019.)

Is A High P/E Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. 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.

How Does Longfor Group Holdings's P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. The image below shows that Longfor Group Holdings has a higher P/E than the average (6.4) P/E for companies in the real estate industry.

Its relatively high P/E ratio indicates that Longfor Group Holdings shareholders think it will perform better than other companies in its industry classification. Clearly the market expects growth, but it isn't guaranteed. 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

Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. When earnings grow, the 'E' increases, over time. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

It's nice to see that Longfor Group Holdings grew EPS by a stonking 25% in the last year. And earnings per share have improved by 14% annually, over the last five years. I'd therefore be a little surprised if its P/E ratio was not relatively high.

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

Don't forget that the P/E ratio considers market capitalization. So it won't reflect the advantage of cash, or disadvantage of debt. 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.

Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.

Longfor Group Holdings's Balance Sheet

Longfor Group Holdings's net debt is 55% of its market cap. This is a reasonably significant level of debt -- all else being equal you'd expect a much lower P/E than if it had net cash.

The Verdict On Longfor Group Holdings's P/E Ratio

Longfor Group Holdings trades on a P/E ratio of 10.2, which is fairly close to the HK market average of 10.2. The significant levels of debt do detract somewhat from the strong earnings growth. The P/E suggests the market isn't confident that growth will be sustained, though.

When the market is wrong about a stock, it gives savvy investors an opportunity. If the reality for a company is not as bad as the P/E ratio indicates, then the share price should increase as the market realizes this. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

Of course, you might find a fantastic investment by looking at a few good candidates. So take a peek at this free list of companies with modest (or no) debt, trading on a P/E below 20.

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.

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