This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll show how you can use China Railway Signal & Communication Corporation Limited's (HKG:3969) P/E ratio to inform your assessment of the investment opportunity. China Railway Signal & Communication has a price to earnings ratio of 9.69, based on the last twelve months. That corresponds to an earnings yield of approximately 10.3%.

View our latest analysis for China Railway Signal & Communication

How Do You Calculate China Railway Signal & Communication's P/E Ratio?

The formula for P/E is:

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

Or for China Railway Signal & Communication:

P/E of 9.69 = HK$3.97 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ HK$0.41 (Based on the trailing twelve months to September 2019.)

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 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 China Railway Signal & Communication's P/E Ratio Compare To Its Peers?

The P/E ratio essentially measures market expectations of a company. You can see in the image below that the average P/E (9.3) for companies in the electronic industry is roughly the same as China Railway Signal & Communication's P/E.

Its P/E ratio suggests that China Railway Signal & Communication 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. Checking factors such as director buying and selling. could help you form your own view on if that will happen.

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.

Most would be impressed by China Railway Signal & Communication earnings growth of 16% in the last year. And earnings per share have improved by 7.1% annually, over the last five years. So one might expect an above average P/E ratio.

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

The 'Price' in P/E reflects the market capitalization of the company. So it won't reflect the advantage of cash, or disadvantage of debt. 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.

China Railway Signal & Communication's Balance Sheet

With net cash of CN¥19b, China Railway Signal & Communication has a very strong balance sheet, which may be important for its business. Having said that, at 29% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Bottom Line On China Railway Signal & Communication's P/E Ratio

China Railway Signal & Communication has a P/E of 9.7. That's around the same as the average in the HK market, which is 10.2. The balance sheet is healthy, and recent EPS growth impressive, but the P/E implies some caution from the market. Because analysts are predicting more growth in the future, one might have expected to see a higher P/E ratio. You can take a closer look at the fundamentals, here.

When the market is wrong about a stock, it gives savvy investors an opportunity. 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 visual report on analyst forecasts could hold the key to an excellent investment decision.

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.

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. Thank you for reading.