This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). To keep it practical, we’ll show how Johnson Electric Holdings Limited’s (HKG:179) P/E ratio could help you assess the value on offer. Johnson Electric Holdings has a price to earnings ratio of 7.06, based on the last twelve months. That means that at current prices, buyers pay HK$7.06 for every HK$1 in trailing yearly profits.

Check out our latest analysis for Johnson Electric Holdings

How Do I Calculate Johnson Electric Holdings’s 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 Johnson Electric Holdings:

P/E of 7.06 = $2.16 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $0.31 (Based on the trailing twelve months to September 2018.)

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 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 even if the current P/E is high, it will reduce over time if the share price stays flat. Then, a lower P/E should attract more buyers, pushing the share price up.

Johnson Electric Holdings saw earnings per share improve by -2.0% last year. And it has bolstered its earnings per share by 6.4% per year over the last five years.

How Does Johnson Electric Holdings’s P/E Ratio Compare To Its Peers?

We can get an indication of market expectations by looking at the P/E ratio. If you look at the image below, you can see Johnson Electric Holdings has a lower P/E than the average (12) in the electrical industry classification.

This suggests that market participants think Johnson Electric Holdings 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. You should delve deeper. I like to check if company insiders have been buying or selling.

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

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

Is Debt Impacting Johnson Electric Holdings’s P/E?

Johnson Electric Holdings has net debt worth 19% of its market capitalization. That’s enough debt to impact the P/E ratio a little; so keep it in mind if you’re comparing it to companies without debt.

The Verdict On Johnson Electric Holdings’s P/E Ratio

Johnson Electric Holdings trades on a P/E ratio of 7.1, which is below the HK market average of 10.6. EPS grew over the last twelve months, and debt levels are quite reasonable. If you believe growth will continue – or even increase – then the low P/E may signify opportunity.

Investors should be looking to buy stocks that the market is wrong about. 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 report on the analyst consensus forecasts could help you make a master move on this stock.

Of course you might be able to find a better stock than Johnson Electric Holdings. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.