The goal of this article is to teach you how to use price to earnings ratios (P/E ratios). We'll look at SCUD Group Limited's (HKG:1399) P/E ratio and reflect on what it tells us about the company's share price. What is SCUD Group's P/E ratio? Well, based on the last twelve months it is 4.54. That is equivalent to an earnings yield of about 22.0%.

See our latest analysis for SCUD 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 SCUD Group:

P/E of 4.54 = CN¥0.219 ÷ CN¥0.048 (Based on the year to December 2019.)

(Note: the above calculation uses the share price in the reporting currency, namely CNY and the calculation results may not be precise due to rounding.)

Is A High Price-to-Earnings Ratio Good?

A higher P/E ratio means that buyers have to pay a higher price for each CN¥1 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.

Does SCUD 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 (9.0) for companies in the electrical industry is higher than SCUD Group's P/E.

This suggests that market participants think SCUD Group will underperform other companies in its industry. Since the market seems unimpressed with SCUD Group, it's quite possible it could surprise on the upside. You should delve deeper. I like to check if company insiders have been buying or selling.

How Growth Rates Impact P/E Ratios

Earnings growth rates have a big influence on P/E ratios. If earnings are growing quickly, then the 'E' in the equation will increase faster than it would otherwise. Therefore, even if you pay a high multiple of earnings now, that multiple will become lower in the future. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.

SCUD Group's earnings per share fell by 44% in the last twelve months.

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. Hypothetically, a company could reduce its future P/E ratio by spending its cash (or taking on debt) to achieve higher earnings.

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).

So What Does SCUD Group's Balance Sheet Tell Us?

SCUD Group's net debt is 83% of its market cap. This is enough debt that you'd have to make some adjustments before using the P/E ratio to compare it to a company with net cash.

The Verdict On SCUD Group's P/E Ratio

SCUD Group's P/E is 4.5 which is below average (9.3) in the HK market. 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.

You might be able to find a better buy than SCUD Group. 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).

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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned. Thank you for reading.