Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll apply a basic P/E ratio analysis to Transtech Optelecom Science Holdings Limited's (HKG:8465), to help you decide if the stock is worth further research. Looking at earnings over the last twelve months, Transtech Optelecom Science Holdings has a P/E ratio of 7.27. In other words, at today's prices, investors are paying HK$7.27 for every HK$1 in prior year profit.

Check out our latest analysis for Transtech Optelecom Science Holdings

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

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

Or for Transtech Optelecom Science Holdings:

P/E of 7.27 = HK$1.000 ÷ HK$0.138 (Based on the trailing twelve months to December 2019.)

(Note: the above calculation results may not be precise due to rounding.)

Is A High Price-to-Earnings Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. 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'.

Does Transtech Optelecom Science Holdings Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio essentially measures market expectations of a company. If you look at the image below, you can see Transtech Optelecom Science Holdings has a lower P/E than the average (16.3) in the communications industry classification.

This suggests that market participants think Transtech Optelecom Science Holdings will underperform other companies in its industry. Since the market seems unimpressed with Transtech Optelecom Science Holdings, it's quite possible it could surprise on the upside. 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

If earnings fall then in the future the 'E' will be lower. 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.

Transtech Optelecom Science Holdings saw earnings per share decrease by 55% last year. And EPS is down 25% a year, over the last 3 years. This might lead to low expectations.

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

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. That means it doesn't take debt or cash into account. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

While growth expenditure doesn't always pay off, the point is that it is a good option to have; but one that the P/E ratio ignores.

Transtech Optelecom Science Holdings's Balance Sheet

With net cash of HK$108m, Transtech Optelecom Science Holdings has a very strong balance sheet, which may be important for its business. Having said that, at 42% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Bottom Line On Transtech Optelecom Science Holdings's P/E Ratio

Transtech Optelecom Science Holdings's P/E is 7.3 which is below average (9.1) in the HK market. The recent drop in earnings per share would almost certainly temper expectations, the relatively strong balance sheet will allow the company time to invest in growth. If it achieves that, then there's real potential that the low P/E could eventually indicate undervaluation.

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. Although we don't have analyst forecasts you could get a better understanding of its growth by checking out this more detailed historical graph of earnings, revenue and cash flow.

Of course you might be able to find a better stock than Transtech Optelecom Science Holdings. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.