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 Poly Culture Group Corporation Limited's (HKG:3636) P/E ratio to inform your assessment of the investment opportunity. Based on the last twelve months, Poly Culture Group's P/E ratio is 6.12. In other words, at today's prices, investors are paying HK$6.12 for every HK$1 in prior year profit.

See our latest analysis for Poly Culture Group

How Do You Calculate A P/E Ratio?

The formula for P/E is:

Price to Earnings Ratio = Share Price (in reporting currency) ÷ Earnings per Share (EPS)

Or for Poly Culture Group:

P/E of 6.12 = HK$5.57 (Note: this is the share price in the reporting currency, namely, CNY ) ÷ HK$0.91 (Based on the year to June 2019.)

Is A High Price-to-Earnings Ratio Good?

The higher the P/E ratio, the higher the price tag of a business, relative to its trailing earnings. 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.

Does Poly Culture Group Have A Relatively High Or Low P/E For Its Industry?

One good way to get a quick read on what market participants expect of a company is to look at its P/E ratio. We can see in the image below that the average P/E (13.6) for companies in the entertainment industry is higher than Poly Culture Group's P/E.

This suggests that market participants think Poly Culture Group 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. It is arguably worth checking if insiders are buying shares, because that might imply they believe the stock is undervalued.

How Growth Rates Impact P/E Ratios

Companies that shrink earnings per share quickly will rapidly decrease the 'E' in the equation. Therefore, even if you pay a low multiple of earnings now, that multiple will become higher in the future. Then, a higher P/E might scare off shareholders, pushing the share price down.

Poly Culture Group shrunk earnings per share by 15% over the last year. And it has shrunk its earnings per share by 10% per year over the last five years. This might lead to muted expectations.

Remember: P/E Ratios Don't Consider The Balance Sheet

It's important to note that the P/E ratio considers the market capitalization, not the enterprise value. So it won't reflect the advantage of cash, or disadvantage of debt. The exact same company would hypothetically deserve a higher P/E ratio if it had a strong balance sheet, than if it had a weak one with lots of debt, because a cashed up company can spend on growth.

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.

Is Debt Impacting Poly Culture Group's P/E?

Poly Culture Group's net debt is considerable, at 170% of its 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 Bottom Line On Poly Culture Group's P/E Ratio

Poly Culture Group's P/E is 6.1 which is below average (10.4) in the HK market. The P/E reflects market pessimism that probably arises from the lack of recent EPS growth, paired with significant leverage.

Investors should be looking to buy stocks that the market is wrong about. As value investor Benjamin Graham famously said, 'In the short run, the market is a voting machine but in the long run, it is a weighing machine. 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 be able to find a better stock than Poly Culture Group. So you may wish to see this free collection of other companies that have grown earnings strongly.

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.