Today, we'll introduce the concept of the P/E ratio for those who are learning about investing. We'll show how you can use China Baofeng (International) Limited's (HKG:3966) P/E ratio to inform your assessment of the investment opportunity. What is China Baofeng (International)'s P/E ratio? Well, based on the last twelve months it is 2.83. That means that at current prices, buyers pay HK$2.83 for every HK$1 in trailing yearly profits.

Check out our latest analysis for China Baofeng (International)

How Do I Calculate A 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 Baofeng (International):

P/E of 2.83 = CNY1.78 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CNY0.63 (Based on the trailing twelve months to June 2019.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each CNY1 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 Does China Baofeng (International)'s P/E Ratio Compare To Its Peers?

The P/E ratio indicates whether the market has higher or lower expectations of a company. We can see in the image below that the average P/E (12.3) for companies in the consumer durables industry is higher than China Baofeng (International)'s P/E.

Its relatively low P/E ratio indicates that China Baofeng (International) shareholders think it will struggle to do as well as other companies in its industry classification. Many investors like to buy stocks when the market is pessimistic about their prospects. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.

How Growth Rates Impact P/E Ratios

Probably the most important factor in determining what P/E a company trades on is the earnings growth. That's because companies that grow earnings per share quickly will rapidly increase the 'E' in the equation. That means unless the share price increases, the P/E will reduce in a few years. And as that P/E ratio drops, the company will look cheap, unless its share price increases.

China Baofeng (International)'s earnings per share fell by 21% in the last twelve months. But over the longer term (5 years) earnings per share have increased by 75%.

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

One drawback of using a P/E ratio is that it considers market capitalization, but not the balance sheet. 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 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.

Is Debt Impacting China Baofeng (International)'s P/E?

China Baofeng (International)'s net debt is considerable, at 113% of its market cap. 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 Verdict On China Baofeng (International)'s P/E Ratio

China Baofeng (International) trades on a P/E ratio of 2.8, which is below the HK market average of 10.3. When you consider that the company has significant debt, and didn't grow EPS last year, it isn't surprising that the market has muted expectations.

Investors have an opportunity when market expectations about a stock are wrong. 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 China Baofeng (International). 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.