This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Xinchen China Power Holdings Limited’s (HKG:1148) P/E ratio could help you assess the value on offer. Xinchen China Power Holdings has a price to earnings ratio of 4.24, based on the last twelve months. In other words, at today’s prices, investors are paying HK$4.24 for every HK$1 in prior year profit.

Check out our latest analysis for Xinchen China Power Holdings

How Do I Calculate A Price To Earnings 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 Xinchen China Power Holdings:

P/E of 4.24 = CN¥0.38 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.089 (Based on the year to June 2018.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that investors are paying a higher price for each HK$1 of company earnings. 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

Companies that shrink earnings per share quickly will rapidly decrease the ‘E’ in the equation. That means unless the share price falls, the P/E will increase in a few years. A higher P/E should indicate the stock is expensive relative to others — and that may encourage shareholders to sell.

Xinchen China Power Holdings shrunk earnings per share by 11% over the last year. And EPS is down 20% a year, over the last 5 years. This might lead to muted expectations.

How Does Xinchen China Power 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 Xinchen China Power Holdings has a lower P/E than the average (10.7) P/E for companies in the auto components industry.

Its relatively low P/E ratio indicates that Xinchen China Power Holdings shareholders think it will struggle to do as well as other companies in its industry classification. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. You should delve deeper. I like to check if company insiders have been buying or selling.

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

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 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.

How Does Xinchen China Power Holdings’s Debt Impact Its P/E Ratio?

Xinchen China Power Holdings’s net debt is considerable, at 298% of its market cap. This level of debt justifies a relatively low P/E, so remain cognizant of the debt, if you’re comparing it to other stocks.

The Verdict On Xinchen China Power Holdings’s P/E Ratio

Xinchen China Power Holdings’s P/E is 4.2 which is below average (10.3) in the HK market. Given meaningful debt, and a lack of recent growth, the market looks to be extrapolating this recent performance; reflecting low expectations for the future.

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.

You might be able to find a better buy than Xinchen China Power 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).

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.