Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. To keep it practical, we'll show how China Evergrande Group's (HKG:3333) P/E ratio could help you assess the value on offer. China Evergrande Group has a price to earnings ratio of 5.55, based on the last twelve months. That corresponds to an earnings yield of approximately 18%.
How Do I Calculate China Evergrande Group's Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)
Or for China Evergrande Group:
P/E of 5.55 = CN¥15.8 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥2.85 (Based on the year to December 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 is not a good or a bad thing per se, but a high P/E does imply buyers are optimistic about the future.
How Does China Evergrande Group's P/E Ratio Compare To Its Peers?
The P/E ratio essentially measures market expectations of a company. As you can see below China Evergrande Group has a P/E ratio that is fairly close for the average for the real estate industry, which is 5.9.
Its P/E ratio suggests that China Evergrande Group shareholders think that in the future it will perform about the same as other companies in its industry classification. So if China Evergrande Group 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
Generally speaking the rate of earnings growth has a profound impact on a company's P/E multiple. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. That means unless the share price increases, the P/E will reduce in a few years. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.
China Evergrande Group's 55% EPS improvement over the last year was like bamboo growth after rain; rapid and impressive. The cherry on top is that the five year growth rate was an impressive 29% per year. So I'd be surprised if the P/E ratio was not above average.
Don't Forget: The P/E Does Not Account For Debt or Bank Deposits
The 'Price' in P/E reflects the market capitalization of the company. That means it doesn't take debt or cash into account. 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.
How Does China Evergrande Group's Debt Impact Its P/E Ratio?
China Evergrande Group has net debt worth a very significant 264% of its market capitalization. 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 Bottom Line On China Evergrande Group's P/E Ratio
China Evergrande Group trades on a P/E ratio of 5.5, which is below the HK market average of 9.8. While the EPS growth last year was strong, the significant debt levels reduce the number of options available to management. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.
Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine.' So this free report on the analyst consensus forecasts could help you make a master move on this stock.
But note: China Evergrande Group may not be the best stock to buy. So take a peek at this free list of interesting companies with strong recent earnings growth (and a P/E ratio below 20).
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.