Despite Its High P/E Ratio, Is China Medical System Holdings Limited (HKG:867) Still Undervalued?

The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). To keep it practical, we'll show how China Medical System Holdings Limited's (HKG:867) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, China Medical System Holdings has a P/E ratio of 12.88. That means that at current prices, buyers pay HK$12.88 for every HK$1 in trailing yearly profits.

See our latest analysis for China Medical System Holdings

How Do I Calculate China Medical System Holdings's Price To Earnings Ratio?

The formula for P/E is:

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

Or for China Medical System Holdings:

P/E of 12.88 = CNY10.70 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CNY0.83 (Based on the trailing twelve months to June 2019.)

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. All else being equal, it's better to pay a low price -- but as Warren Buffett said, 'It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price'.

How Does China Medical System Holdings's P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. The image below shows that China Medical System Holdings has a P/E ratio that is roughly in line with the pharmaceuticals industry average (12.2).

SEHK:867 Price Estimation Relative to Market, January 23rd 2020
SEHK:867 Price Estimation Relative to Market, January 23rd 2020

China Medical System Holdings's P/E tells us that market participants think its prospects are roughly in line with its industry. So if China Medical System Holdings actually outperforms its peers going forward, that should be a positive for the share price. I would further inform my view by checking insider buying and selling., among other things.

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. When earnings grow, the 'E' increases, over time. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. Then, a lower P/E should attract more buyers, pushing the share price up.

Most would be impressed by China Medical System Holdings earnings growth of 13% in the last year. And earnings per share have improved by 22% annually, over the last five years. So one might expect an above average P/E ratio.

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

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. Thus, the metric does not reflect cash or debt held by the company. In theory, a company can lower its future P/E ratio by using cash or debt to invest in growth.

Spending on growth might be good or bad a few years later, but the point is that the P/E ratio does not account for the option (or lack thereof).

How Does China Medical System Holdings's Debt Impact Its P/E Ratio?

The extra options and safety that comes with China Medical System Holdings's CN¥202m net cash position means that it deserves a higher P/E than it would if it had a lot of net debt.

The Bottom Line On China Medical System Holdings's P/E Ratio

China Medical System Holdings trades on a P/E ratio of 12.9, which is above its market average of 10.4. Its net cash position supports a higher P/E ratio, as does its solid recent earnings growth. Therefore it seems reasonable that the market would have relatively high expectations of the company

Investors should be looking to buy stocks that the market is wrong about. People often underestimate remarkable growth -- so investors can make money when fast growth is not fully appreciated. 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.