This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll look at High Fashion International Limited’s (HKG:608) P/E ratio and reflect on what it tells us about the company’s share price. Based on the last twelve months, High Fashion International’s P/E ratio is 13.24. That means that at current prices, buyers pay HK$13.24 for every HK$1 in trailing yearly profits.

Check out our latest analysis for High Fashion International

How Do You Calculate A P/E Ratio?

The formula for price to earnings is:

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

Or for High Fashion International:

P/E of 13.24 = HK$1.85 ÷ HK$0.14 (Based on the year to June 2018.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each HK$1 the company has earned over the last year. 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 Growth Rates Impact P/E Ratios

When earnings fall, the ‘E’ decreases, over time. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. So while a stock may look cheap based on past earnings, it could be expensive based on future earnings.

High Fashion International’s earnings per share fell by 16% in the last twelve months. And it has shrunk its earnings per share by 39% per year over the last five years. This could justify a pessimistic P/E.

How Does High Fashion International’s P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. As you can see below, High Fashion International has a higher P/E than the average company (9.9) in the luxury industry.

High Fashion International’s P/E tells us that market participants think the company will perform better than its industry peers, going forward. Clearly the market expects growth, but it isn’t guaranteed. So investors should always consider the P/E ratio alongside other factors, such as whether company directors have been buying shares.

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 taking on debt (or spending its remaining cash).

Such expenditure might be good or bad, in the long term, but the point here is that the balance sheet is not reflected by this ratio.

High Fashion International’s Balance Sheet

High Fashion International has net debt worth 85% of its market capitalization. If you want to compare its P/E ratio to other companies, you should absolutely keep in mind it has significant borrowings.

The Verdict On High Fashion International’s P/E Ratio

High Fashion International’s P/E is 13.2 which is above average (10.4) in the HK market. With meaningful debt and a lack of recent earnings growth, the market has high expectations that the business will earn more in the future.

Investors should be looking to buy stocks that the market is wrong about. If the reality for a company is better than it expects, you can make money by buying and holding for the long term. Although we don’t have analyst forecasts, shareholders might want to examine this detailed historical graph of earnings, revenue and cash flow.

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.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.