This article is written for those who want to get better at using price to earnings ratios (P/E ratios). We'll look at Hilong Holding Limited's (HKG:1623) P/E ratio and reflect on what it tells us about the company's share price. Hilong Holding has a P/E ratio of 7.69, based on the last twelve months. That is equivalent to an earnings yield of about 13%.

See our latest analysis for Hilong Holding

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 Hilong Holding:

P/E of 7.69 = CN¥0.67 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ CN¥0.088 (Based on the trailing twelve months 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.

Does Hilong Holding Have A Relatively High Or Low P/E For Its Industry?

The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Hilong Holding has a lower P/E than the average (30.7) P/E for companies in the energy services industry.

Its relatively low P/E ratio indicates that Hilong Holding 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. You should delve deeper. I like to check if company insiders have been buying or selling.

How Growth Rates Impact P/E Ratios

If earnings fall then in the future the 'E' will be lower. 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.

It's great to see that Hilong Holding grew EPS by 25% in the last year. But earnings per share are down 16% per year over the last five years.

A Limitation: P/E Ratios Ignore Debt and Cash In The Bank

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. 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).

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).

How Does Hilong Holding's Debt Impact Its P/E Ratio?

Net debt totals a substantial 201% of Hilong Holding's market cap. If you want to compare its P/E ratio to other companies, you must keep in mind that these debt levels would usually warrant a relatively low P/E.

The Verdict On Hilong Holding's P/E Ratio

Hilong Holding has a P/E of 7.7. That's below the average in the HK market, which is 10. The company may have significant debt, but EPS growth was good last year. If the company can continue to grow earnings, then the current P/E may be unjustifiably low.

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. So this free visualization of the analyst consensus on future earnings could help you make the right decision about whether to buy, sell, or hold.

You might be able to find a better buy than Hilong Holding. 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).

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 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. Thank you for reading.