This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We’ll show how you can use China Communications Construction Company Limited’s (HKG:1800) P/E ratio to inform your assessment of the investment opportunity. China Communications Construction has a price to earnings ratio of 5.65, based on the last twelve months. In other words, at today’s prices, investors are paying HK$5.65 for every HK$1 in prior year profit.
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How Do I Calculate China Communications Construction’s Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)
Or for China Communications Construction:
P/E of 5.65 = CN¥7.16 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥1.27 (Based on the trailing twelve months to September 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio implies that investors pay a higher price for the earning power of the business. 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.’
How Growth Rates Impact P/E Ratios
Earnings growth rates have a big influence on P/E ratios. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. A lower P/E should indicate the stock is cheap relative to others — and that may attract buyers.
It’s nice to see that China Communications Construction grew EPS by a stonking 27% in the last year. And it has bolstered its earnings per share by 9.9% per year over the last five years. With that performance, I would expect it to have an above average P/E ratio.
How Does China Communications Construction’s P/E Ratio Compare To Its Peers?
We can get an indication of market expectations by looking at the P/E ratio. The image below shows that China Communications Construction has a lower P/E than the average (11.4) P/E for companies in the construction industry.
This suggests that market participants think China Communications Construction will underperform other companies in its industry. While current expectations are low, the stock could be undervalued if the situation is better than the market assumes. If you consider the stock interesting, further research is recommended. For example, I often monitor director buying and selling.
Remember: P/E Ratios Don’t Consider The Balance Sheet
Don’t forget that the P/E ratio considers market capitalization. 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 taking on debt (or spending its remaining 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 Communications Construction’s Debt Impact Its P/E Ratio?
China Communications Construction has net debt worth a very significant 111% 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 Communications Construction’s P/E Ratio
China Communications Construction trades on a P/E ratio of 5.6, which is below the HK market average of 10.8. The company may have significant debt, but EPS growth was good last year. The low P/E ratio suggests current market expectations are muted, implying these levels of growth will not continue.
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. So this free visual report on analyst forecasts could hold the key to an excellent investment decision.
But note: China Communications Construction 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).
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.
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.