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 Smart Globe Holdings Limited's (HKG:8485) P/E ratio could help you assess the value on offer. Looking at earnings over the last twelve months, Smart Globe Holdings has a P/E ratio of 4.41. That is equivalent to an earnings yield of about 22.7%.

Check out our latest analysis for Smart Globe Holdings

How Do I Calculate A Price To Earnings Ratio?

The formula for price to earnings is:

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

Or for Smart Globe Holdings:

P/E of 4.41 = HK$0.10 ÷ HK$0.02 (Based on the year to September 2019.)

Is A High P/E Ratio Good?

A higher P/E ratio implies that investors pay a higher price for the earning power of the business. That isn't a good or a bad thing on its own, but a high P/E means that buyers have a higher opinion of the business's prospects, relative to stocks with a lower P/E.

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

One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. The image below shows that Smart Globe Holdings has a lower P/E than the average (12.2) P/E for companies in the commercial services industry.

This suggests that market participants think Smart Globe Holdings will underperform other companies in its industry. Since the market seems unimpressed with Smart Globe 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

P/E ratios primarily reflect market expectations around earnings growth rates. Earnings growth means that in the future the 'E' will be higher. That means even if the current P/E is high, it will reduce over time if the share price stays flat. A lower P/E should indicate the stock is cheap relative to others -- and that may attract buyers.

In the last year, Smart Globe Holdings grew EPS like Taylor Swift grew her fan base back in 2010; the 103% gain was both fast and well deserved. The sweetener is that the annual five year growth rate of 16% is also impressive. With that kind of growth rate we would generally expect a high P/E ratio.

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

The 'Price' in P/E reflects the market capitalization of the company. Thus, the metric does not reflect cash or debt held by the company. 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).

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).

So What Does Smart Globe Holdings's Balance Sheet Tell Us?

With net cash of HK$32m, Smart Globe Holdings has a very strong balance sheet, which may be important for its business. Having said that, at 33% of its market capitalization the cash hoard would contribute towards a higher P/E ratio.

The Verdict On Smart Globe Holdings's P/E Ratio

Smart Globe Holdings has a P/E of 4.4. That's below the average in the HK market, which is 10.2. It grew its EPS nicely over the last year, and the healthy balance sheet implies there is more potential for growth. One might conclude that the market is a bit pessimistic, given the low P/E ratio.

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 shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.

You might be able to find a better buy than Smart Globe 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.