This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll apply a basic P/E ratio analysis to Chanhigh Holdings Limited's (HKG:2017), to help you decide if the stock is worth further research. Based on the last twelve months, Chanhigh Holdings's P/E ratio is 3.35. In other words, at today's prices, investors are paying HK$3.35 for every HK$1 in prior year profit.

See our latest analysis for Chanhigh 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 Chanhigh Holdings:

P/E of 3.35 = CN¥0.274 ÷ CN¥0.082 (Based on the trailing twelve months to December 2019.)

(Note: the above calculation uses the share price in the reporting currency, namely CNY and the calculation results may not be precise due to rounding.)

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 necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.

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

We can get an indication of market expectations by looking at the P/E ratio. If you look at the image below, you can see Chanhigh Holdings has a lower P/E than the average (7.9) in the construction industry classification.

Its relatively low P/E ratio indicates that Chanhigh Holdings shareholders think it will struggle to do as well as other companies in its industry classification. Many investors like to buy stocks when the market is pessimistic about their prospects. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

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

Chanhigh Holdings's earnings made like a rocket, taking off 196% last year. Regrettably, the longer term performance is poor, with EPS down per year over 3 years.

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 investing in growth. That means taking on debt (or spending its 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.

Is Debt Impacting Chanhigh Holdings's P/E?

Chanhigh Holdings's net debt is considerable, at 218% of its market cap. This is a relatively high level of debt, so the stock probably deserves a relatively low P/E ratio. Keep that in mind when comparing it to other companies.

The Verdict On Chanhigh Holdings's P/E Ratio

Chanhigh Holdings's P/E is 3.4 which is below average (9.5) in the HK market. While the EPS growth last year was strong, the significant debt levels reduce the number of options available to management. If it continues to grow, then the current low P/E may prove to be unjustified.

Investors have an opportunity when market expectations about a stock are wrong. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. Although we don't have analyst forecasts you might want to assess this data-rich visualization of earnings, revenue and cash flow.

You might be able to find a better buy than Chanhigh 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).

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.