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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 Kwan On Holdings Limited's (HKG:1559) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Kwan On Holdings's P/E ratio is 21.19. That means that at current prices, buyers pay HK$21.19 for every HK$1 in trailing yearly profits.

See our latest analysis for Kwan On Holdings

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

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

Or for Kwan On Holdings:

P/E of 21.19 = HK$0.58 ÷ HK$0.027 (Based on the year to September 2018.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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 Growth Rates Impact P/E Ratios

Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. That means even if the current P/E is low, it will increase over time if the share price stays flat. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.

Kwan On Holdings increased earnings per share by 7.3% last year. And earnings per share have improved by 3.5% annually, over the last five years. Unfortunately, earnings per share are down 6.2% a year, over 3 years.

How Does Kwan On Holdings's P/E Ratio Compare To Its Peers?

The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Kwan On Holdings has a higher P/E than the average (12.6) P/E for companies in the construction industry.

Kwan On Holdings's P/E tells us that market participants think the company will perform better than its industry peers, going forward. 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.

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

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 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.

Kwan On Holdings's Balance Sheet

The extra options and safety that comes with Kwan On Holdings's HK$75m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.

The Verdict On Kwan On Holdings's P/E Ratio

Kwan On Holdings's P/E is 21.2 which is above average (12) in the HK market. Earnings improved over the last year. Also positive, the relatively strong balance sheet will allow for investment in growth -- and the P/E indicates shareholders that will happen!

Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. Although we don't have analyst forecasts, shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.

You might be able to find a better buy than Kwan On Holdings. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

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.